QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended December 31, 2009

OR

o

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the transition period from: to

Commission File Number: 01-33901

Fifth Street Finance Corp.

(Exact name of registrant as specified in its charter)

Delaware

26-1219283

(State or jurisdiction of
incorporation or organization)

(I.R.S. Employer
Identification No.)

10 Bank Street, 12th Floor

White Plains, NY

10606

(Address of principal executive office)

(Zip Code)

REGISTRANTS
TELEPHONE NUMBER, INCLUDING AREA CODE:(914) 286-6800

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

Name of Each Exchange

Title of Each Class

on Which Registered

Common Stock, par value $0.01 per share

New York Stock Exchange

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

None

Indicate by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months
(or for such shorter periods as the registrant was required to file such reports),
and (2) has been subject to such filing requirements for the past 90 days. YES þ NO o

Indicate by check mark whether the registrant has submitted electronically and posted on its
corporate Web site, if any, every Interactive Data File required to be submitted and posted
pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months
(or for such shorter period that the registrant was required to submit and post such files). YES o NO o

Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of
large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the
Exchange Act. (Check one):

Large accelerated filer o

Accelerated filer þ

Non-accelerated filer o

Smaller reporting company o

(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Act) YES o NO þ

The
registrant had 44,923,407 shares of common stock outstanding as
of January 31, 2010.

FIFTH STREET FINANCE CORP.

FORM 10-Q FOR THE QUARTER ENDED DECEMBER 31, 2009

TABLE OF CONTENTS

PART I FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements (unaudited):

Consolidated Balance Sheets as of December 31, 2009 and September 30, 2009

3

Consolidated Statements of Operations for the three months ended December 31, 2009 and December 31, 2008

4

Consolidated Statements of Changes in Net Assets for the three months ended December 31, 2009 and
December 31, 2008

5

Consolidated Statements of Cash Flows for the three months ended December 31, 2009 and December 31, 2008

6

Consolidated Schedule of Investments as of December 31, 2009

7

Consolidated Schedule of Investments as of September 30, 2009

9

Notes to Consolidated Financial Statements

10

Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations

Increase (decrease) in payments received in advance from portfolio
companies

58,640

(43,635

)

Purchase of investments

(144,203,972

)

(23,650,000

)

Proceeds from the sale of investments

106,000



Principal payments received on investments (scheduled repayments
and revolver paydowns)

1,973,601

1,588,600

Principal payments received on investments (payoffs)

3,885,000

8,100,000

Net cash used by operating activities

(129,400,679

)

(8,532,634

)

Cash flows from financing activities:

Dividends paid in cash

(9,740,934

)

(6,449,056

)

Repurchases of common stock



(462,482

)

Borrowings

38,000,000



Offering costs paid

(281,358

)

(268,065

)

Net cash provided (used) by financing activities

27,977,708

(7,179,603

)

Net decrease in cash and cash equivalents

(101,422,971

)

(15,712,237

)

Cash and cash equivalents, beginning of period

113,205,287

22,906,376

Cash and cash equivalents, end of period

$

11,782,316

$

7,194,139

Supplemental Information:

Cash paid for interest

$



$

78,491

Non-cash financing activities:

Issuance of shares of common stock under dividend reinvestment plan

$

486,392

$

762,557

See notes to Consolidated Financial Statements.

6

Fifth Street Finance Corp.

Consolidated Schedule of Investments
December 31, 2009

(unaudited)

Portfolio Company /Type of Investment (1)(2)(5)

Industry

Principal (8)

Cost

Fair Value

Control Investments (3)

Lighting By Gregory, LLC

Housewares & Specialties

First Lien Term Loan A, 9.75% due 2/28/2013

$

4,800,003

$

4,728,589

$

3,127,062

First Lien Term Loan B, 14.5% due 2/28/2013

7,149,491

6,906,440

4,557,267

97.38% membership interest

410,000



12,045,029

7,684,329

Total Control Investments

$

12,045,029

$

7,684,329

Affiliate Investments (4)

OCurrance, Inc.

Data Processing & Outsourced Services

First Lien Term Loan A, 16.875% due 3/21/2012

10,634,486

10,494,238

10,349,447

First Lien Term B, 16.875%, 3/21/2012

2,541,222

2,503,000

2,621,304

1.75% Preferred Membership interest in OCurrance Holding Co., LLC

130,413

130,413

3.3% Membership Interest in OCurrance Holding Co., LLC

250,000

32,544

13,377,651

13,133,708

CPAC, Inc. (9)

Household Products & Specialty Chemicals

Second Lien Term Loan, 17.5% due 4/13/2012

11,529,260

9,506,805

4,533,635

Charge-off
of cost basis of impaired loan (12)

(4,000,000

)



2,297 Shares of Common Stock

2,297,000



7,803,805

4,533,635

MK Network, LLC

Healthcare technology

First Lien Term Loan A, 13.5% due 6/1/2012

9,500,000

9,246,350

9,174,370

First Lien Term Loan B, 17.5% due 6/1/2012

5,132,300

4,909,388

4,967,708

First Lien Revolver, Prime + 1.5% (10% floor), due 6/1/2010 (10)







11,030 Membership Units (6)

771,575



14,927,313

14,142,078

Martini Park, LLC (9)

Restaurants

First Lien Term Loan, 14% due 2/20/2013

4,481,179

3,408,351

2,163,318

5% membership interest

650,000



4,058,351

2,163,318

Caregiver Services, Inc.

Healthcare services

Second Lien Term Loan A, LIBOR+6.85% (12% floor) due 2/25/2013

8,213,244

7,773,472

7,930,944

Second Lien Term Loan B, 16.5% due 2/25/2013

14,354,020

13,604,561

13,632,445

1,080,399 shares of Series A Preferred Stock

1,080,398

1,283,413

22,458,431

22,846,802

Total Affiliate Investments

$

62,625,551

$

56,819,541

Non-Control/Non-Affiliate Investments (7)

Best Vinyl Acquisition Corporation (9)

Building Products

Second Lien Term Loan, 12% due 3/30/2013

7,000,000

6,795,756

6,215,211

25,641 Shares of Series A Preferred Stock

253,846



25,641 Shares of Common Stock

2,564



7,052,166

6,215,211

Repechage Investments Limited

Restaurants

First Lien Term Loan, 15.5% due 10/16/2011

4,078,392

3,732,828

3,713,772

7,500 shares of Series A Preferred Stock of Elephant & Castle, Inc.

750,000

450,391

4,482,828

4,164,163

Traffic Control & Safety Corporation

Construction and Engineering

Second Lien Term Loan, 15% due 6/29/2014

19,455,418

19,166,095

17,998,409

24,750 shares of Series B Preferred Stock

247,500

22,267

25,000 shares of Common Stock

2,500



19,416,095

18,020,676

Nicos Polymers & Grinding Inc. (9)

Environmental & facilities services

First Lien Term Loan A, LIBOR+5% (10% floor), due 7/17/2012

3,107,802

3,040,465

2,012,718

First Lien Term Loan B, 13.5% due 7/17/2012

6,029,934

5,713,125

3,672,544

3.32% Interest in Crownbrook Acquisition I LLC

168,086



8,921,676

5,685,262

TBA Global, LLC (9)

Media: Advertising

Second Lien Term Loan A, LIBOR+5% (10% floor), due 8/3/2010

2,597,034

2,591,616

2,592,839

Second Lien Term Loan B, 14.5% due 8/3/2012

10,908,692

10,563,343

10,475,280

53,994 Senior Preferred Shares

215,975

68,194

191,977 Shares A Shares

191,977



13,562,911

13,136,313

Fitness Edge, LLC

Leisure Facilities

First Lien Term Loan A, LIBOR+5.25% (10% floor), due 8/8/2012

1,625,000

1,616,481

1,631,352

First Lien Term Loan B, 15% due 8/8/2012

5,525,898

5,446,967

5,415,939

1,000 Common Units

42,908

78,516

7,106,356

7,125,807

Filet of Chicken (9)

Food Distributors

Second Lien Term Loan, 14.5% due 7/31/2012

9,355,200

9,002,871

8,879,569

9,002,871

8,879,569

Boot Barn (9)

Footwear and Apparel

Second Lien Term Loan, 14.5% due 10/3/2013

22,777,049

22,456,116

22,411,307

24,706 shares of Series A Preferred Stock

247,060

3,563

1,308 shares of Common Stock

131



22,703,307

22,414,870

Premier Trailer Leasing, Inc.

Trailer Leasing Services

Second Lien Term Loan, 16.5% due 10/23/2012

18,004,329

17,063,645

9,029,545

285 shares of Common Stock

1,140



17,064,785

9,029,545

Pacific Press Technologies, Inc.

Second Lien Term Loan, 14.75% due 1/10/2013

Capital Goods

9,883,125

9,704,723

9,558,931

33,463 shares of Common Stock

344,513

186,927

10,049,236

9,745,858

Rose Tarlow, Inc. (9)

Home Furnishing Retail

First Lien Term Loan, 12% due 1/25/2014

10,256,438

10,090,286

8,833,012

First Lien Revolver, LIBOR+4% (9% floor) due 1/25/2014 (10)

1,550,000

1,539,451

1,362,433

0.00% membership interest in RTMH Acquisition Company (14)

1,275,000



0.00% membership interest in RTMH Acquisition Company (14)

25,000



12,929,737

10,195,445

Goldco, LLC

Second Lien Term Loan, 17.5% due 1/31/2013

Restaurants

8,106,452

7,978,514

8,037,316

7,978,514

8,037,316

Rail Acquisition Corp.

Manufacturing - Mechanical Products

First Lien Term Loan, 17% due 4/1/2013

15,547,535

15,309,653

14,907,004

15,309,653

14,907,004

Western Emulsions, Inc.

Emulsions Manufacturing

Second Lien Term Loan, 15% due 6/30/2014

17,637,889

17,377,502

18,026,589

17,377,502

18,026,589

Storytellers Theaters Corporation

Entertainment - Theaters

First Lien Term Loan, 15% due 7/16/2014

7,321,893

7,219,043

7,276,577

First Lien Revolver, LIBOR+3.5% (10% floor), due 7/16/2014

500,000

485,001

419,783

1,692 shares of Common Stock

169



20,000 shares of Preferred Stock

200,000

150,831

7,904,213

7,847,191

HealthDrive Corporation (9)

Healthcare services

First Lien Term Loan A, 10% due 7/17/2013

7,700,000

7,489,893

7,857,789

First Lien Term Loan B, 13% due 7/17/2013

10,101,861

9,961,861

9,470,380

First Lien Revolver, 12% due 7/17/2013

500,000

486,000

565,603

17,937,754

17,893,772

idX Corporation

Merchandise Display

Second Lien Term Loan, 14.5% due 7/1/2014

13,384,423

13,098,630

12,932,749

13,098,630

12,932,749

Cenegenics, LLC

Healthcare services

First Lien Term Loan, 17% due 10/27/2013

10,125,354

9,848,237

9,997,392

116,237 Common Units (6)

151,108

556,487

9,999,345

10,553,879

IZI Medical Products, Inc.

Healthcare technology

First Lien Term Loan A, 12% due 3/31/2014

5,400,000

5,313,407

5,397,055

First Lien Term Loan B, 16% due 3/31/2014

17,043,917

16,369,225

16,615,099

First Lien Revolver, 10% due 3/31/2014 (11)



(42,500

)

(42,500

)

453,755 Preferred units of IZI Holdings, LLC

453,755

552,751

22,093,887

22,522,405

Trans-Trade, Inc.

Air freight & logistics

First Lien Term Loan, 15.5% due 9/10/2014

11,086,572

10,905,626

11,108,326

First Lien Revolver, 12% due 9/10/2014 (11)

(37,333

)

(37,333

)

10,868,293

11,070,993

Riverlake Equity Partners II, LP

Multi-sector holdings

1.63% limited partnership interest (13)





Riverside Fund IV, LP

Multi-sector holdings

0.25% limited partnership interest

153,972

153,972

153,972

153,972

ADAPCO, Inc.

Fertilizers & agricultural chemicals

First Lien Term Loan A, 10% due 12/17/2014

10,000,000

9,718,695

9,718,695

First Lien Term Loan B, 14% due 12/17/2014

14,011,667

13,618,912

13,618,912

First Lien Term Revolver, 10% due 12/17/2014

4,250,000

3,969,461

3,969,461

27,307,068

27,307,068

Ambath/Rebath Holdings, Inc.

Home improvement retail

First Lien Term Loan A, LIBOR+7% (10% floor) due 12/30/2014

10,000,000

9,715,375

9,715,375

First Lien Term Loan B, 15% due 12/30/2014

22,003,056

21,385,956

21,385,956

First Lien Term Revolver, LIBOR+6.5% (9.5% floor) due
12/30/2014 (11)

(79,650

)

(79,650

)

31,021,681

31,021,681

JTC Education, Inc.

Education services

First Lien Term Loan, LIBOR+9.5% (12.5% floor) due 12/31/2014

31,250,000

30,308,777

30,308,777

First Lien Revolver, LIBOR+9.5% (12.5% floor) due 12/31/2014 (11)



(295,000

)

(295,000

)

30,013,777

30,013,777

Tegra Medical, LLC

Healthcare equipment

First Lien Term Loan A, LIBOR+7% (10% floor) due 12/31/2014

28,000,000

27,431,767

27,431,767

First Lien Term Loan B, 14% due 12/31/2014

18,301,017

17,935,455

17,935,455

First Lien Revolver, LIBOR+7% (10% floor) due 12/31/2014 (11)



(78,667

)

(78,667

)

45,288,555

45,288,555

Total Non-Control/Non-Affiliate Investments

$

388,644,812

$

372,189,670

Total Portfolio Investments

$

463,315,392

$

436,693,540

(1)

All debt investments are income producing. Equity is non-income producing unless otherwise noted.

(2)

See Note 3 for summary geographic location.

(3)

Control Investments are defined by the Investment Company Act of 1940 (1940 Act) as
investments in companies in which the Company owns more than 25% of the voting securities or
maintains greater than 50% of the board representation.

(4)

Affiliate Investments are defined by the 1940 Act as investments in companies in which the
Company owns between 5% and 25% of the voting securities.

(5)

Equity ownership may be held in shares or units of companies related to the portfolio companies.

(6)

Income producing through payment of dividends or distributions.

(7)

Non-Control/Non-Affiliate Investments are defined by the 1940 Act as investments that are
neither Control Investments nor Affiliate Investments.

(8)

Principal includes accumulated PIK interest and is net of repayments.

(9)

Interest rates have been adjusted on certain term loans and revolvers. These rate adjustments
are temporary in nature due to financial or payment covenant violations in the original credit
agreements, or permanent in nature per loan amendment or waiver documents. The table below
summarizes these rate adjustments by portfolio company:

7

Portfolio Company

Effective date

Cash interest

PIK interest

Reason

Rose Tarlow, Inc.

January 1, 2009

+0.5% on Term Loan, + 3.0% on Revolver

+ 2.5% on Term Loan

Tier pricing per waiver agreement

Martini Park, LLC

October 1, 2008

- 6.0% on Term Loan

+ 6.0% on Term Loan

Per waiver agreement

Best Vinyl Acquisition Corporation

April 1, 2008

+ 0.5% on Term Loan

Per loan amendment

Nicos Polymers & Grinding, Inc.

February 10, 2008

+ 2.0% on Term Loan A & B

Per waiver agreement

TBA Global, LLC

February 15, 2008

+ 2.0% on Term Loan B

Per waiver agreement

Filet of Chicken

January 1, 2009

+ 1.0% on Term Loan

Tier pricing per waiver agreement

Boot Barn

January 1, 2009

+ 1.0% on Term Loan

+ 2.5% on Term Loan

Tier pricing per waiver agreement

Premier Trailer Leasing, Inc.

August 4, 2009

+ 4.0% on Term Loan

Default interest per credit agreement

HealthDrive Corporation

April 30, 2009

+ 2.0% on Term Loan A

Per waiver agreement

(10)

Revolving credit line has been suspended and is deemed unlikely to be renewed in the future.

(11)

Amounts represent unearned income related to undrawn commitments.

(12)

All or a portion of the loan is considered permanently impaired and, accordingly, the
charge-off of the cost basis has been recorded as a realized loss for financial reporting
purposes.

Control Investments are defined by the Investment Company Act of 1940 (1940 Act) as investments in companies in which the Company owns more than
25% of the voting securities or maintains greater than 50% of the board representation.

(4)

Affiliate Investments are defined by the 1940 Act as investments in companies in which the Company owns between 5% and 25% of the voting securities.

(5)

Equity ownership may be held in shares or units of companies related to the portfolio companies.

(6)

Income producing through payment of dividends or distributions.

(7)

Non-Control/Non-Affiliate Investments are defined by the 1940 Act as investments that are neither Control Investments nor Affiliate Investments.

(8)

Principal includes accumulated PIK interest and is net of repayments.

(9)

Interest rates have been adjusted on certain term loans and revolvers. These rate adjustments are temporary in nature due to financial or payment
covenant violations in the original credit agreements, or permanent in nature per loan amendment or waiver documents. The table below summarizes
these rate adjustments by portfolio company:

Portfolio Company

Effective date

Cash interest

PIK interest

Reason

CPAC, Inc.

November 21, 2008



+ 1.0% on Term Loan

Per waiver agreement

Rose Tarlow, Inc.

January 1, 2009

+0.5% on Term Loan, +
3.0% on Revolver

+ 2.5% on Term Loan

Tier pricing per waiver agreement

Martini Park, LLC

October 1, 2008

- 6.0% on Term Loan

+ 6.0% on Term Loan

Per waiver agreement

Best Vinyl Acquisition Corporation

April 1, 2008

+ 0.5% on Term Loan



Per loan amendment

Nicos Polymers & Grinding, Inc.

February 10, 2008



+ 2.0% on Term Loan A & B

Per waiver agreement

TBA Global, LLC

February 15, 2008



+ 2.0% on Term Loan A & B

Per waiver agreement

Filet of Chicken

January 1, 2009

+ 1.0% on Term Loan



Tier pricing per waiver agreement

Boot Barn

January 1, 2009

+ 1.0% on Term Loan

+ 2.5% on Term Loan

Tier pricing per waiver agreement

HealthDrive Corporation

April 30, 2009

+ 2.0% on Term Loan A



Per waiver agreement

(10)

Revolving credit line has been suspended and is deemed unlikely to be renewed in the future.

(11)

Amounts represent unearned income related to undrawn commitments.

(12)

All or a portion of the loan is considered permanently impaired and, accordingly, the
charge-off of the cost basis has been recorded as a realized loss for financial reporting purposes.

Fifth Street Mezzanine Partners III, L.P. (the Partnership), a Delaware
limited partnership, was organized on February 15, 2007 to primarily invest in debt
securities of small and/or middle market companies. FSMPIII GP, LLC was the
Partnerships general partner (the General Partner). The Partnerships investments
were managed by Fifth Street Management LLC (the Investment Adviser). The General
Partner and Investment Adviser were under common ownership.

Effective January 2, 2008, the Partnership merged with and into Fifth Street
Finance Corp. (the Company), an externally managed, closed-end, non-diversified
management investment company that has elected to be treated as a business
development company under the Investment Company Act of 1940 (the 1940 Act). The
merger involved the exchange of shares between companies under common control. In
accordance with the guidance on exchanges of shares between entities under common
control, the Companys results of operations and cash flows for the year ended
September 30, 2008 are presented as if the merger had occurred as of October 1, 2007.
Accordingly, no adjustments were made to the carrying value of assets and liabilities
(or the cost basis of investments) as a result of the merger. The Company is managed by the Investment Adviser. Prior to January 2, 2008, references to
the Company are to the Partnership. Since January 2, 2008,
references to the Company,
FSC, we or our are to Fifth Street Finance Corp., unless the context otherwise
requires.

The Company also has certain wholly-owned subsidiaries which hold certain
portfolio investments of the Company. The subsidiaries are consolidated with the
Company, and the portfolio investments held by the subsidiaries are included in the
Companys consolidated financial statements. All significant intercompany balances
and transactions have been eliminated.

On June 17, 2008, the Company completed an initial public offering of
10,000,000 shares of its common stock at the offering price of $14.12 per share. On
July 21, 2009, the Company completed a follow-on public offering of 9,487,500 shares
of its common stock at the offering price of $9.25 per share. On September 25, 2009,
the Company completed a follow-on public offering of 5,520,000 shares of its common
stock at the offering price of $10.50 per share. On January 27, 2010, the Company
completed a follow-on public offering of 7,000,000 shares of its common stock at the
offering price of $11.20 per share. The Companys shares are currently listed on the
New York Stock Exchange under the symbol FSC.

On
February 3, 2010, the Companys wholly-owned subsidiary, Fifth Street
Mezzanine Partners IV, L.P., received a license, effective February 1, 2010, from the
United States Small Business Administration, or SBA, to operate as a small business
investment company, or SBIC, under Section 301(c) of the Small Business Investment
Act of 1958. SBICs are designated to stimulate
the flow of private equity capital to eligible small businesses. Under SBA
regulations, SBICs may make loans to eligible small businesses and invest in the
equity securities of small businesses.

The
SBIC license allows the Companys SBIC subsidiary to obtain
leverage by issuing SBA-guaranteed debentures, subject to the issuance of a capital
commitment by the SBA and other customary procedures. SBA-guaranteed debentures are
non-recourse, interest only debentures with interest payable semi-annually and have a
ten year maturity. The principal amount of SBA-guaranteed debentures is not required
to be paid prior to maturity but may be prepaid at any time without penalty. The
interest rate of SBA-guaranteed debentures is fixed at the time of issuance at a
market-driven spread over U.S. Treasury Notes with 10-year maturities.

SBA
regulations currently limit the amount that the Companys SBIC subsidiary may borrow
up to a maximum of $150 million when it has at least $75 million in regulatory
capital, receives a capital commitment from the SBA and has been through an
examination by the SBA subsequent to licensing. As of
December 31, 2009, the Companys SBIC
subsidiary had funded four pre-licensing investments for a total of $73 million and
held $2 million in cash, which is included as regulatory capital. The SBA is expected to
issue a capital commitment to the Companys SBIC subsidiary in the near future, at which point the
SBIC subsidiary would be able to access a portion of the capital commitment. However, the Company
cannot predict the timing for completion of an examination by the SBA, at which time the SBA reviews the
Companys SBIC subsidiary and determines whether it conforms
with SBA rules and regulations. The Company expects to have access to the full amount over time.

10

FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

The SBA restricts the ability of SBICs to repurchase their capital stock. SBA
regulations also include restrictions on a change of control or transfer of an
SBIC and require that SBICs invest idle funds in accordance with SBA regulations.
In addition, the Companys SBIC subsidiary may also be limited in its ability to make
distributions to the Company if it does not have sufficient capital, in accordance with SBA
regulations.

The
Companys SBIC subsidiary is subject to regulation
and oversight by the SBA, including requirements with respect to maintaining certain
minimum financial ratios and other covenants. Receipt of an SBIC license does not
assure that the SBIC subsidiary will receive SBA-guaranteed debenture funding and is
dependent upon the SBIC subsidiary continuing to be in compliance with SBA regulations and policies.

The SBA, as a creditor, will have a superior claim to our SBIC subsidiarys
assets over the Companys stockholders in the event the Company liquidates the SBIC
subsidiary or the SBA exercises its remedies under the SBA-guaranteed debentures issued by the
SBIC subsidiary upon an event of default.

The Company applied for exemptive relief from the SEC to permit it to
exclude the debt of the SBIC subsidiary guaranteed by the SBA from the 200% asset
coverage test under the 1940 Act. If the Company receives an exemption for this SBA
debt, the Company would have increased flexibility under the 200% asset coverage test.

The Company cannot assure you that it will receive the exemptive relief from the
SEC or a capital commitment from the SBA necessary to begin
issuing SBA-guaranteed debentures.

Note 2. Significant Accounting Policies

FASB Accounting Standards Codification

The issuance of FASB Accounting Standards Codification tm (the
Codification) on July 1, 2009 (effective for interim or annual reporting periods
ending after September 15, 2009), changes the way that U.S. generally accepted
accounting principles (GAAP) are referenced. Beginning on that date, the
Codification officially became the single source of authoritative nongovernmental
GAAP; however, SEC registrants must also consider rules, regulations, and
interpretive guidance issued by the SEC or its staff. The switch affects the way
companies refer to GAAP in financial statements and in their accounting policies. All
existing standards that were used to create the Codification became superseded.
Instead, references to standards will consist solely of the number used in the
Codifications structural organization. For example, it is no longer proper to refer
to FASB Statement No. 157, Fair Value Measurement , which is now Codification Topic
820 Fair Value Measurements and Disclosures (ASC 820).

11

FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

Consistent with the effective date of the Codification, financial statements for
periods ending after September 15, 2009, refer to the Codification structure, not
pre-Codification historical GAAP.

Basis of Presentation and Liquidity:

The Consolidated Financial Statements of the Company have been prepared in
accordance with GAAP and pursuant to the requirements for reporting on Form 10-Q and
Regulation S-X. The financial results of the Companys portfolio investments are not
consolidated in the Companys financial statements.

The
Company has evaluated all subsequent events through February 9, 2010, the date of this
filing.

Although the Company expects to fund the growth of its investment portfolio
through the net proceeds of the recent and future equity offerings, the Companys
dividend reinvestment plan, and issuances of senior securities or future borrowings,
to the extent permitted by the 1940 Act, the Company cannot assure that its plans to
raise capital will be successful. In addition, the Company intends to distribute to
its stockholders between 90% and 100% of its taxable income each year in order to
satisfy the requirements applicable to RICs under Subchapter M of the Internal
Revenue Code (Code). Consequently, the Company may not have the funds or the
ability to fund new investments, to make additional investments in its portfolio
companies, to fund its unfunded commitments to portfolio companies or to repay
borrowings. In addition, the illiquidity of its portfolio investments may make it
difficult for the Company to sell these investments when desired and, if the Company
is required to sell these investments, the Company may realize significantly less than their
recorded value.

Use of Estimates:

The preparation of financial statements in conformity with GAAP requires
management to make certain estimates and assumptions affecting amounts reported in
the financial statements and accompanying notes. These estimates are based on the
information that is currently available to the Company and on various other
assumptions that the Company believes to be reasonable under the circumstances.
Actual results could differ materially from those estimates under different
assumptions and conditions. The most significant estimate inherent in the preparation
of the Companys consolidated financial statements is the valuation of investments
and the related amounts of unrealized appreciation and depreciation.

The consolidated financial statements include portfolio investments at fair
value of $436.7 million and $299.6 million at December 31, 2009 and September 30,
2009, respectively. The portfolio investments represent 106.4% and 73.0% of
stockholders equity at December 31, 2009 and September 30, 2009, respectively, and
their fair values have been determined by the Companys Board of Directors in good
faith in the absence of readily available market values. Because of the inherent
uncertainty of valuation, the determined values may differ significantly from the
values that would have been used had a ready market existed for the investments, and
the differences could be material. The illiquidity of these portfolio investments may
make it difficult for the Company to sell these investments when desired and, if the
Company is required to sell these investments, it may realize significantly less than
the investments recorded value.

The Company classifies its investments in accordance with the requirements of
the 1940 Act. Under the 1940 Act, Control Investments are defined as investments in
companies in which the Company owns more than 25% of the voting securities or has
rights to maintain greater than 50% of the board representation; Affiliate
Investments are defined as investments in companies in which the Company owns
between 5% and 25% of the voting securities; and Non-Control/Non-Affiliate
Investments are defined as investments that are neither Control Investments nor
Affiliate Investments.

12

FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

Significant Accounting Policies:

a) Valuation:

As described below, effective October 1, 2008, the Company adopted ASC Topic 820
Fair Value Measurements and Disclosures (ASC 820). In accordance with that
standard, the Company changed its presentation for all periods presented to net
unearned fees against the associated debt investments. Prior to the adoption of ASC
820 on October 1, 2008, the Company reported unearned fees as a single line item on
the Consolidated Balance Sheets and Consolidated Schedules of Investments. This
change in presentation had no impact on the overall net cost or fair value of the
Companys investment portfolio and had no impact on the Companys financial position
or results of operations.

b) Fair Value Measurements:

In September 2006, the Financial Accounting Standards Board issued
ASC 820, which was effective for fiscal years beginning after November 15, 2007.
ASC 820 defines fair value as the price at which an asset could be exchanged in a
current transaction between knowledgeable, willing parties. A liabilitys fair value
is defined as the amount that would be paid to transfer the liability to a new
obligor, not the amount that would be paid to settle the liability with the creditor.
Where available, fair value is based on observable market prices or parameters or
derived from such prices or parameters. Where observable prices or inputs are not
available, valuation techniques are applied. These valuation techniques involve some
level of management estimation and judgment, the degree of which is dependent on the
price transparency for the investments or market and the investments complexity.

Assets and liabilities recorded at fair value in the Companys Consolidated
Balance Sheets are categorized based upon the level of judgment associated with the
inputs used to measure their fair value. Hierarchical levels, defined by ASC 820 and
directly related to the amount of subjectivity associated with the inputs to fair
valuation of these assets and liabilities, are as follows:

Level 2  Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data at the measurement date for substantially the full term of the assets or liabilities.



Level 3  Unobservable inputs that reflect managements best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.

13

FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

Realized gain or loss on the sale of investments is the difference between the
proceeds received from dispositions of portfolio investments and their stated costs.
Realized losses may also be recorded in connection with the Companys determination
that certain investments are permanently impaired.

Interest income, adjusted for amortization of premium and accretion of original
issue discount, is recorded on an accrual basis to the extent that such amounts are
expected to be collected. The Company stops accruing interest on investments when it
is determined that interest is no longer collectible.

Distributions of earnings from portfolio companies are recorded as dividend
income when the distribution is received.

The Company has investments in debt securities which contain a payment-in-kind
or PIK interest provision. PIK interest is computed at the contractual rate
specified in each investment agreement and added to the principal balance of the
investment and recorded as income.

Fee income consists of the monthly collateral management fees that the Company
receives in connection with its debt investments and the accreted portion of the debt
origination and exit fees.

The Company capitalizes upfront loan origination fees received in connection
with investments. The unearned fee income from such fees is accreted into fee income
based on the effective interest method over the life of the investment. In connection
with its investment, the Company sometimes receives nominal cost equity that is
valued as part of the negotiation process with the particular portfolio company. When
the Company receives nominal cost equity, the Company allocates its cost basis in its
investment between its debt securities and its nominal cost equity at the time of
origination. Any resulting discount from recording the loan is accreted into fee
income over the life of the loan.

As of December 31, 2009, the Company was entitled to receive exit fees upon the
future exit of certain investments. These fees will typically be paid to the Company
upon the sooner to occur of (i) a sale of the borrower or substantially all of the
assets of the borrower, (ii) the maturity date of the loan, or (iii) the date when
full prepayment of the loan occurs. Exit fees, which are contractually payable by
borrowers to the Company, previously were to be recognized by the Company on a cash
basis when received and not accrued or otherwise included in net investment income
until received. None of the loans with exit fees, all of which were originated in
2008 and 2009, have been exited and, as a result, no exit fees were recognized.
Beginning with the quarter ended December 31, 2009, the Company recognizes income
pertaining to contractual exit fees on an accrual basis and adds exit fee income to
the principal balance of the related loan to the extent the Company determines that
collection of the exit fee income is probable. Additionally, the Company includes
the cash flows of contractual exit fees that it determines are probable of collection
in determining the fair value of its loans. The Company believes the effect of this cumulative adjustment in the quarter
ended December 31, 2009 is not material to its financial statements as of any date or for any period.

Cash and Cash Equivalents:

Cash and cash equivalents consist of demand deposits and highly liquid
investments with maturities of three months or less, when acquired. The Company
places its cash and cash equivalents with financial institutions and, at times, cash
held in bank accounts may exceed the Federal Deposit Insurance Corporation insured
limit.

Offering Costs:

Offering costs consist of fees paid to the underwriters, in addition to legal,
accounting, regulatory and printing fees that are related to the Companys follow-on
offerings which closed on July 21, 2009 and September 25, 2009. Accordingly,
approximately $12,000 of offering costs (net of the underwriting fees) were
charged to capital during the three months ended December 31, 2009.

Income Taxes:

Prior to the merger of the Partnership with and into the Company, the
Partnership was treated as a partnership for federal and state income tax purposes.
The Partnership generally did not record a provision for income taxes because the
partners report their shares of the partnership income or loss on their income tax
returns. Accordingly,
the taxable income was passed through to the partners and the Partnership was
not subject to an entity level tax as of December 31, 2007.

As a partnership, Fifth Street Mezzanine Partners III, LP filed a calendar year
tax return for a short year initial period from February 15, 2007 through
December 31, 2007. Upon the merger, Fifth Street Finance Corp., the surviving
C-Corporation, made an election to be treated as a RIC under the Code and adopted a
September 30 tax year-end. Accordingly, the first RIC tax return has been filed for
the tax year beginning January 1, 2008 and ended September 30, 2008.

14

FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

As a RIC, the Company is not subject to federal income tax on the portion of its
taxable income and gains distributed currently to its stockholders as a dividend. The
Company anticipates distributing between 90% and 100% of its taxable income and
gains, within the Subchapter M rules, and thus the Company anticipates that it will
not incur any federal or state income tax at the RIC level. As a RIC, the Company is
also subject to a federal excise tax based on distributive requirements of its
taxable income on a calendar year basis (e.g., calendar year 2009). The Company
anticipates timely distribution of its taxable income within the tax
rules; however, the Company incurred a de minimis federal excise tax for calendar year 2008 and
has accrued a de minimis federal excise tax for calendar year 2009. In addition, the Company
may incur a federal excise tax in future years.

The purpose of the Companys taxable subsidiaries is to permit the Company to
hold equity investments in portfolio companies which are pass through entities for
federal tax purposes in order to comply with the source income requirements
contained in the RIC tax requirements. The taxable subsidiaries are not consolidated
with the Company for income tax purposes and may generate income tax expense as a
result of their ownership of certain portfolio investments. This income tax expense,
if any, is reflected in the Companys Consolidated Statements of Operations. The
Company uses the asset and liability method to account for its taxable subsidiaries
income taxes. Using this method, the Company recognizes deferred tax assets and
liabilities for the estimated future tax effects attributable to temporary
differences between financial reporting and tax bases of assets and liabilities. In
addition, the Company recognizes deferred tax benefits associated with net operating
carry forwards that it may use to offset future tax obligations. The Company measures
deferred tax assets and liabilities using the enacted tax rates expected to apply to
taxable income in the years in which we expect to recover or settle those temporary
differences.

The Company adopted Financial Accounting Standards Board ASC Topic 740
Accounting for Uncertainty in Income Taxes (ASC 740) at inception on February 15,
2007. ASC 740 provides guidance for how uncertain tax positions should be recognized,
measured, presented, and disclosed in the consolidated financial statements. ASC 740
requires the evaluation of tax positions taken or expected to be taken in the course
of preparing the Companys tax returns to determine whether the tax positions are
more-likely-than-not of being sustained by the applicable tax authority. Tax
positions not deemed to meet the more-likely-than-not threshold are recorded as a tax
benefit or expense in the current year. Adoption of ASC 740 was applied to all open
taxable years as of the effective date. The adoption of ASC 740 did not have an
effect on the financial position or results of operations of the Company as there was
no liability for unrecognized tax benefits and no change to the beginning capital of
the Company. Managements determinations regarding ASC 740 may be subject to review
and adjustment at a later date based upon factors including, but not limited to, an
ongoing analysis of tax laws, regulations and interpretations thereof.

Guarantees and Indemnification Agreements:

The Company follows ASC 460 Guarantors Accounting and Disclosure Requirements
for Guarantees, Including Indirect Guarantees of Indebtedness of Others (ASC 460).
ASC 460 elaborates on the disclosure requirements of a guarantor in its interim and
annual financial statements about its obligations under certain guarantees that it
has issued. It also requires a guarantor to recognize, at the inception of a
guarantee, for those guarantees that are covered by ASC 460, the fair value of the
obligation undertaken in issuing certain guarantees. The Interpretation has had no
impact on the Companys consolidated financial statements.

Recent Accounting Pronouncements

In
January 2010, the FASB issued Improving Disclosures about Fair Value Measurements (ASC 820) which is effective
for interim and annual reporting periods beginning after December 15, 2009.
The main provisions of the update relate to transfers in and out of Levels 1 and 2 and activity within Level 3 fair value measurements.
The Company is evaluating the impact
of the statement on its business.

In
October 2009, the FASB issued Accounting Standards Update 2009-13, Revenue
Recognition (Topic 605)  Multiple-Deliverable Revenue Arrangements which addresses
accounting for multiple deliverable arrangements to enable vendors to account for
products separately rather than as a combined unit. The amendments are effective
prospectively for fiscal years beginning on or after June 15, 2010. The Company does
not expect the adoption of this guidance to have a material impact on either its
financial position or results of operations.

In
September 2009, the FASB issued Accounting Standards Update 2009-12, Fair
Value Measurements and Disclosures (Topic 820)  Investments in Certain Entities That
Calculate Net Asset Value per Share (or Its Equivalent), which provides guidance on
estimating the fair value of an alternative investment, amending ASC
820-10. The amendment is effective for interim and annual periods ending after December 15, 2009.
The adoption of this guidance did not have a material impact
on either the Companys financial position or results of operations.

15

FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

In February 2007, the FASB issued ASC Topic 825-10 Financial Instruments (ASC
825-10) , which provides companies with an option to report selected financial
assets and liabilities at fair value. The objective of ASC 825-10 is to reduce both
complexity in accounting for financial instruments and the volatility in earnings
caused by measuring related assets and liabilities differently, and is effective as
of the beginning of an entitys first fiscal year beginning after November 15, 2007.
Early adoption is permitted as of the beginning of the previous fiscal year provided
that the entity makes that choice in the first 120 days of that fiscal year and also
elects to apply the provisions of ASC 820. While ASC 825-10 became effective for the
Companys 2009 fiscal year, the Company did not elect the fair value measurement
option for any of its financial assets or liabilities.

In December 2007, the FASB issued ASC Topic 810 Noncontrolling Interests in
Consolidated Financial (ASC 810). ASC 810 establishes accounting and reporting
standards for the noncontrolling interest in a subsidiary and for the deconsolidation
of a subsidiary. ASC 810 requires that noncontrolling interests in subsidiaries be
reported in the equity section of the controlling companys balance sheet. It also
changes the manner in which the net income of the subsidiary is reported and
disclosed in the controlling companys income statement. ASC 810 is effective for
fiscal years, and interim periods within those fiscal years, beginning on or after
December 15, 2008. The adoption of ASC 810
did not have any impact on either the Companys financial position or results of operations.

Effective January 1, 2009 the Company adopted the guidance included in ASC Topic
815 Derivatives and Hedging (ASC 815), which requires additional disclosures for
derivative instruments and hedging activities. The Company does not have any
derivative instruments nor has it engaged in any hedging activities. ASC 815 has no
impact on the Companys financial statements.

Effective July 1, 2009 the Company adopted the provisions of ASC Topic 855
Subsequent Events (ASC 855). ASC 855 incorporates the subsequent events guidance
contained in the auditing standards literature into authoritative accounting
literature. It also requires entities to disclose the date through which they have
evaluated subsequent events and whether the date corresponds with the release of
their financial statements. See Note 2  Significant Accounting Policies  Basis of
Presentation and Liquidity for this new disclosure.

In June 2009, the FASB issued SFAS No. 166, Accounting for Transfers of
Financial Assets  an amendment of FASB Statement No. 140 (SFAS 166) (to be
included in ASC 860 Transfers and Servicing). SFAS 166 will require more
information about transfers of financial assets, eliminates the qualifying special
purpose entity (QSPE) concept, changes the requirements for derecognizing financial
assets and requires additional disclosures. SFAS 166 is effective for the first
annual reporting period that begins after November 15, 2009. The Company does not
anticipate that SFAS 166 will have a material impact on the Companys financial
statements. This statement has not yet been codified.

Note 3. Portfolio Investments

At December 31, 2009, 106.4% of stockholders equity or $436.7 million was
invested in 32 long-term portfolio investments and 2.9% of stockholders equity or
$11.8 million was invested in cash and cash equivalents. In comparison, at
September 30, 2009, 73.0% of stockholders equity or $299.6 million was invested in
28 long-term portfolio investments and 27.6% of stockholders equity or
$113.2 million was invested in cash and cash equivalents. As of December 31, 2009,
all of the Companys debt investments were secured by first or second priority liens
on the assets of the portfolio companies. Moreover, the Company held equity
investments in certain of its portfolio companies consisting of common stock, preferred stock or
limited liability company interests designed to provide the Company with an
opportunity for an enhanced rate of return. These instruments generally do not
produce a current return, but are held for potential investment appreciation and
capital gain.

16

FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

At December 31, 2009 and September 30, 2009, $351.4 million and $281.0 million,
respectively, of the Companys portfolio debt investments at fair value were at fixed
rates, which represented approximately 81% and 95%, respectively, of the Companys
total portfolio of debt investments at fair value. During the three months ended
December 31, 2009, the Company recorded a $106,000 reduction to a previously recorded
realized loss. During the three months ended December 31, 2008, the Company recorded
no realized gains or losses on investments. During the three months ended December
31, 2009 and 2008, the Company recorded unrealized appreciation (depreciation) of
$1.0 million and ($18.5 million), respectively.

The composition of the Companys investments as of December 31, 2009 and
September 30, 2009 at cost and fair value was as follows:

December 31, 2009

September 30, 2009

Cost

FV

Cost

FV

Investments in debt securities

$

452,998,802

$

433,023,271

$

317,069,667

$

295,921,400

Investments in equity securities

10,316,590

3,670,269

10,162,618

3,689,737

Total

$

463,315,392

$

436,693,540

$

327,232,285

$

299,611,137

The following table presents the financial instruments carried at fair value as
of December 31, 2009, by caption on the Companys Consolidated Balance Sheet for each
of the three levels of hierarchy established by ASC 820.

Level 1

Level 2

Level 3

Total

Control investments

$



$



$

7,684,329

$

7,684,329

Affiliate investments





56,819,541

56,819,541

NC/NA investments





372,189,670

372,189,670

Total investments at fair value

$



$



$

436,693,540

$

436,693,540

The following table provides a roll-forward in the changes in fair value from
September 30, 2009 to December 31, 2009, for all investments for which the Company
determines fair value using unobservable (Level 3) factors. When a determination is
made to classify a financial instrument within Level 3 of the valuation hierarchy,
the determination is based upon the fact that the unobservable factors are the most
significant to the overall fair value measurement. However, Level 3 financial
instruments typically include, in addition to the unobservable or Level 3 components,
observable components (that is, components that are actively quoted and can be
validated by external sources). Accordingly, the appreciation (depreciation) in the
table below includes changes in fair value due in part to observable factors that are
part of the valuation methodology.

Control

Affiliate

Non-control/Non-Affiliate

investments

investments

investments

Total

Fair value as of September 30, 2009

$

5,691,107

$

64,748,560

$

229,171,470

$

299,611,137

Total realized gains (losses)









Change in unrealized appreciation (depreciation)

1,993,222

399,934

(1,393,862

)

999,294

Purchases, issuances, settlements and other, net



(8,328,953

)

144,412,062

136,083,109

Transfers in (out) of Level 3









Fair value as of December 31, 2009

$

7,684,329

$

56,819,541

$

372,189,670

$

436,693,540

17

FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

Concurrent with its adoption of ASC 820, effective October 1, 2008, the Company
augmented the valuation techniques it uses to estimate the fair value of its debt
investments where there is not a readily available market value (Level 3). Prior to
October 1, 2008, the Company estimated the fair value of its Level 3 debt investments
by first estimating the enterprise value of the portfolio company which issued the
debt investment. To estimate the enterprise value of a portfolio company, the Company
analyzed various factors, including the portfolio companies historical and projected
financial results. Typically, private companies are valued based on multiples of
EBITDA (Earning Before Interest, Taxes, Depreciation and Amortization), cash flow,
net income, revenues or, in limited
instances, book value.

In estimating a multiple to use for valuation purposes, the Company looked to
private merger and acquisition statistics, discounted public trading multiples or
industry practices. In some cases, the best valuation methodology may have been a
discounted cash flow analysis based on future projections. If a portfolio company was
distressed, a liquidation analysis may have provided the best indication of
enterprise value.

If there was adequate enterprise value to support the repayment of the Companys
debt, the fair value of the Level 3 loan or debt security normally corresponded to
cost plus the amortized original issue discount unless the borrowers condition or
other factors lead to a determination of fair value at a different amount.

Beginning on October 1, 2008, the Company also introduced a bond yield model to
value these investments based on the present value of expected cash flows. The
primary inputs into the model are market interest rates for debt with similar
characteristics and an adjustment for the portfolio companys credit risk. The credit
risk component of the valuation considers several factors including financial
performance, business outlook, debt priority and collateral position. During the
three months ended December 31, 2009 and 2008, the Company recorded net unrealized
appreciation (depreciation) of $1.0 million and ($18.5 million), respectively, on its
investments. For the three months ended December 31, 2009, the Companys net
unrealized appreciation consisted of $1.0 million resulting from the adoption of ASC
820 and $0.2 million of fair value adjustments resulting from the recognition of exit
fees, offset by unrealized depreciation of ($0.2 million) resulting from declines in
EBITDA or market multiples of its portfolio companies requiring closer monitoring or
performing below expectations.

The table below summarizes the changes in the Companys investment portfolio
from September 30, 2009 to December 31, 2009.

Debt

Equity

Total

Fair value at September 30, 2009

$

295,921,400

$

3,689,737

$

299,611,137

New investments

144,050,000

153,972

144,203,972

Redemptions/repayments

(5,858,601

)



(5,858,601

)

Net accrual of PIK interest income

1,436,580



1,436,580

Accretion of original issue discount

220,943



220,943

Recognition of unearned income

(3,946,778

)



(3,946,778

)

Recognition of exit fee income

26,993



26,993

Net unrealized appreciation (depreciation)

1,172,734

(173,440

)

999,294

Net changes from unrealized to realized







Fair value at December 31, 2009

$

433,023,271

$

3,670,269

$

436,693,540

The
Companys off-balance sheet arrangements consisted of $32.1 million and
$9.8 million of unfunded commitments to provide debt financing to its portfolio
companies or to fund limited partnership interests as of December 31, 2009 and
September 30, 2009, respectively. Such commitments involve, to varying degrees,
elements of credit risk in excess of the amount recognized in the balance sheet and
are not reflected on the Companys Consolidated Balance Sheets.

18

FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

A summary of the composition of the unfunded commitments (consisting of
revolvers, term loans and limited partnership interests) as of December 31, 2009 and
September 30, 2009 is shown in the table below:

December 31, 2009

September 30, 2009

Storyteller Theaters Corporation

$

1,500,000

$

1,750,000

HealthDrive Corporation

1,500,000

1,500,000

IZI Medical Products, Inc.

2,500,000

2,500,000

Trans-Trade, Inc.

2,000,000

2,000,000

Riverlake Equity Partners II, LP (limited partnership interest)

1,000,000

1,000,000

Riverside Fund IV, LP (limited partnership interest)

846,028

1,000,000

ADAPCO, Inc.

5,750,000



AmBath/ReBath
Holdings, Inc.

3,000,000



JTC
Education, Inc.

10,000,000



Tegra
Medical, LLC

4,000,000



Total

$

32,096,028

$

9,750,000

Summaries of the composition of the Companys investment portfolio at cost and
fair value as a percentage of total investments are shown in the following tables:

December 31, 2009

September 30, 2009

Cost:

First lien debt

$

290,315,153

62.66

%

$

153,207,248

46.82

%

Second lien debt

162,683,649

35.11

%

163,862,419

50.08

%

Purchased equity

4,170,368

0.90

%

4,170,368

1.27

%

Equity grants

5,992,250

1.29

%

5,992,250

1.83

%

Limited partnership interests

153,972

0.04

%



0.00

%

Total

$

463,315,392

100.00

%

$

327,232,285

100.00

%

December 31, 2009

September 30, 2009

Fair value:

First lien debt

$

280,768,502

64.29

%

$

142,016,942

47.40

%

Second lien debt

152,254,769

34.87

%

153,904,458

51.37

%

Purchased equity

344,851

0.08

%

517,181

0.17

%

Equity grants

3,171,446

0.73

%

3,172,556

1.06

%

Limited partnership interests

153,972

0.03

%



0.00

%

Total

$

436,693,540

100.00

%

$

299,611,137

100.00

%

19

FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

The Company invests in portfolio companies located in the United States. The
following tables show the portfolio composition by geographic region at cost and fair
value as a percentage of total investments. The geographic composition is determined
by the location of the corporate headquarters of the portfolio company, which may not
be indicative of the primary source of the portfolio companys business.

December 31, 2009

September 30, 2009

Cost:

Northeast

$

144,819,526

31.26

%

$

103,509,164

31.63

%

West

99,041,212

21.38

%

98,694,596

30.16

%

Southeast

66,746,884

14.41

%

39,463,350

12.06

%

Midwest

53,161,643

11.47

%

22,980,368

7.02

%

Southwest

99,546,127

21.48

%

62,584,807

19.13

%

Total

$

463,315,392

100.00

%

$

327,232,285

100.00

%

December 31, 2009

September 30, 2009

Fair value:

Northeast

$

131,357,296

30.08

%

$

87,895,220

29.34

%

West

93,670,102

21.45

%

93,601,893

31.24

%

Southeast

67,070,755

15.36

%

39,858,633

13.30

%

Midwest

52,692,384

12.07

%

22,841,167

7.62

%

Southwest

91,903,003

21.04

%

55,414,224

18.50

%

Total

$

436,693,540

100.00

%

$

299,611,137

100.00

%

20

FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

The composition of the Companys portfolio by industry at cost and fair value as
of December 31, 2009 and September 30, 2009 were as follows:

December 31, 2009

September 30, 2009

Cost:

Healthcare services

$

50,395,530

10.88

%

$

50,826,822

15.53

%

Healthcare equipment

45,288,555

9.77

%



0.00

%

Healthcare technology

37,021,200

7.99

%

37,201,082

11.37

%

Home improvement retail

31,021,681

6.70

%



0.00

%

Education services

30,013,777

6.48

%



0.00

%

Fertilizers & agricultural chemicals

27,307,068

5.89

%



0.00

%

Footwear and apparel

22,703,307

4.90

%

22,423,009

6.85

%

Construction and engineering

19,416,095

4.19

%

19,275,031

5.89

%

Emulsions manufacturing

17,377,502

3.75

%

11,743,630

3.59

%

Trailer leasing services

17,064,785

3.68

%

17,064,785

5.21

%

Restaurants

16,519,693

3.57

%

20,288,245

6.20

%

Manufacturing  mechanical products

15,309,653

3.30

%

15,416,411

4.71

%

Media  Advertising

13,562,911

2.93

%

13,403,441

4.10

%

Data processing and outsourced services

13,377,651

2.89

%

13,473,611

4.12

%

Merchandise display

13,098,630

2.83

%

13,014,576

3.98

%

Home furnishing retail

12,929,737

2.79

%

12,855,762

3.93

%

Housewares & specialties

12,045,029

2.60

%

12,045,029

3.68

%

Air freight and logistics

10,868,293

2.35

%

10,758,896

3.29

%

Capital goods

10,049,236

2.17

%

9,965,792

3.05

%

Food distributors

9,002,871

1.94

%

8,922,946

2.73

%

Environmental & facilities services

8,921,676

1.93

%

8,924,801

2.73

%

Entertainment  theaters

7,904,213

1.71

%

7,601,085

2.32

%

Household products/ specialty chemicals

7,803,805

1.68

%

7,803,805

2.38

%

Leisure facilities

7,106,356

1.53

%

7,187,169

2.20

%

Building products

7,052,166

1.52

%

7,036,357

2.14

%

Multi-sector holdings

153,972

0.03

%



0.00

%

Total

$

463,315,392

100.00

%

$

327,232,285

100.00

%

December 31, 2009

September 30, 2009

Fair value:

Healthcare services

$

51,294,453

11.75

%

$

51,576,258

17.21

%

Healthcare equipment

45,288,555

10.37

%



0.00

%

Healthcare technology

36,664,483

8.40

%

36,762,574

12.27

%

Home improvement retail

31,021,681

7.10

%



0.00

%

Education services

30,013,777

6.87

%



0.00

%

Fertilizers & agricultural chemicals

27,307,068

6.25

%



0.00

%

Footwear and apparel

22,414,870

5.13

%

22,082,721

7.37

%

Emulsions manufacturing

18,026,589

4.13

%

12,130,945

4.05

%

Construction and engineering

18,020,676

4.13

%

17,852,292

5.96

%

Manufacturing  mechanical products

14,907,004

3.41

%

15,081,138

5.03

%

Restaurants

14,364,797

3.29

%

17,811,015

5.94

%

Media  Advertising

13,136,313

3.01

%

13,099,203

4.37

%

Data processing and outsourced services

13,133,708

3.01

%

13,289,816

4.44

%

Merchandise display

12,932,749

2.96

%

13,074,682

4.36

%

Air freight and logistics

11,070,993

2.54

%

10,799,619

3.60

%

Home furnishing retail

10,195,445

2.33

%

10,336,401

3.45

%

Capital goods

9,745,858

2.23

%

9,766,485

3.26

%

Trailer leasing services

9,029,545

2.07

%

9,860,940

3.29

%

Food distributors

8,879,569

2.03

%

8,979,657

3.00

%

Entertainment  theaters

7,847,191

1.80

%

7,541,582

2.52

%

Housewares & specialties

7,684,329

1.76

%

5,691,107

1.90

%

Leisure facilities

7,125,807

1.63

%

7,144,897

2.38

%

Building products

6,215,211

1.42

%

6,158,908

2.06

%

Environmental & facilities services

5,685,262

1.30

%

6,122,236

2.04

%

Household products/ specialty chemicals

4,533,635

1.04

%

4,448,661

1.50

%

Multi-sector holdings

153,972

0.04

%



0.00

%

Total

$

436,693,540

100.00

%

$

299,611,137

100.00

%

21

FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

The Companys investments are generally in small and mid-sized companies in a
variety of industries. At December 31, 2009 and September 30, 2009, the Company had
one investment that was greater than 10% of the total investment portfolio at fair
value. This investment comprised 10.4% of the total portfolio at fair value. Income,
consisting of interest, dividends, fees, other investment income, and realization of
gains or losses on equity interests, can fluctuate upon repayment of an investment or
sale of an equity interest and in any given year can be highly concentrated among
several investments. For the three months ended December 31, 2009 and September 30,
2009, no individual investment produced income that exceeded 10% of investment
income.

Note 4. Fee Income

The Company receives a variety of fees in the ordinary course of business,
including origination fees. The Company accounts for fee income in accordance with
ASC Topic 605-25 Multiple-Element Arrangements (ASC 605-25), which addresses
certain aspects of a companys accounting for arrangements containing multiple
revenue-generating activities. In some arrangements, the different revenue-generating
activities (deliverables) are sufficiently separable and there exists sufficient
evidence of their fair values to separately account for some or all of the
deliverables (i.e., there are separate units of accounting). ASC 605-25 states that
the total consideration received for the arrangement be allocated to each unit based
upon each units relative fair value. In other arrangements, some or all of the
deliverables are not independently functional, or there is not sufficient evidence of
their fair values to account for them separately. The timing of revenue recognition
for a given unit of accounting depends on the nature of the deliverable(s) in that
accounting unit (and the corresponding revenue recognition model) and whether the
general conditions for revenue recognition have been met. Fee income for which fair
value cannot be reasonably ascertained is recognized using the interest method in
accordance with ASC 310-20 Nonrefundable Fees and Other Costs.

The Company capitalizes upfront debt origination fees received in connection
with financings and the unearned income from such fees is accreted into fee income
over the life of the financing. In accordance with ASC 820, the net balance is
reflected as unearned income in the cost and fair value of the respective
investments.

Accumulated unearned fee income activity for the three months ended December 31,
2009 and 2008 was as follows:

Three months

Three months

ended December 31, 2009

ended December 31, 2008

Beginning unearned fee income balance

$

5,589,630

$

5,236,265

Net fees received

4,861,907

982,763

Unearned fee income recognized

(915,129

)

(1,063,524

)

Ending unearned fee income balance

$

9,536,408

$

5,155,504

As of December 31, 2009, the Company was entitled to receive approximately
$7.8 million in aggregate exit fees across 12 portfolio investments upon the future
exit of those investments. These fees will typically be paid to the Company upon the
sooner to occur of (i) a sale of the borrower or substantially all of the assets of
the borrower, (ii) the maturity date of the loan, or (iii) the date when full
prepayment of the loan occurs. Exit fees, which are contractually payable by
borrowers to the Company, previously were to be recognized on a cash basis when
received and not accrued or otherwise included in net investment income until
received. None of the loans with exit fees, all of which were originated in 2008 and
2009, have been exited and, as a result, no exit fees were recognized. Beginning
with the quarter ended December 31, 2009, the Company recognizes income
pertaining to contractual exit fees on an accrual basis and adds exit fee income to
the principal balance of the related loan to the extent the Company determines that
collection of the exit fee income is probable. Additionally, the Company includes
the cash flows of contractual exit fees that it determines are probable of collection
in determining the fair value of its loans. The Company believes the effect of this
cumulative adjustment in the quarter ended December 31, 2009 is not material
to its financial statements as of any date or for any period. For the three months
ended December 31, 2009, fee income included approximately $27,000 of income from accrued exit fees.

The Companys decision to accrue exit fees and the amount of each accrual
involves subjective judgments and determinations based on the risks and uncertainties
associated with the Companys ability to ultimately collect exit fees relating to
each individual loan, including the actions of the senior note holders to block the
payment of the exit fees, the Companys relationship with the equity sponsor, the
potential modification and extension of a loan, and consideration of situations where
exit fees have been added after the initial investment as a remedy for a covenant
violation.

22

FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

Note 5. Share Data and Stockholders Equity

Effective January 2, 2008, the Partnership merged with and into the Company. At
the time of the merger, all outstanding partnership interests in the Partnership were
exchanged for 12,480,972 shares of common stock of the Company. An additional 26
fractional shares were payable to the stockholders in cash.

On June 17, 2008, the Company completed an initial public offering of
10,000,000 shares of its common stock at the offering price of $14.12 per share. The
net proceeds totaled approximately $129.5 million net of investment banking
commissions of approximately $9.9 million and offering costs of approximately
$1.8 million.

On July 21, 2009, the Company completed a follow-on public offering of
9,487,500 shares of its common stock, which included the underwriters exercise of
their over-allotment option, at the offering price of $9.25. The net proceeds totaled
approximately $82.7 million after deducting investment banking commissions of
approximately $4.4 million and offering costs of $0.7 million.

On September 25, 2009, the Company completed a follow-on public offering of
5,520,000 shares of its common stock, which included the underwriters exercise of
their over-allotment option, at the offering price of $10.50. The net proceeds
totaled approximately $54.9 million after deducting investment banking commissions of
approximately $2.8 million and offering costs of approximately $0.3 million.

No dilutive instruments were outstanding and reflected in the Companys
Consolidated Balance Sheet at December 31, 2009 or September 30, 2009. The following
table sets forth the weighted average shares outstanding for computing basic and
diluted earnings per common share for the three months ended December 31, 2009 and
December 31, 2008.

Three months

Three months

ended December 31, 2009

ended December 31, 2008

Weighted average common shares outstanding, basic and diluted

37,880,435

22,562,191

On December 13, 2007, the Company adopted a dividend reinvestment plan that
provides for reinvestment of its distributions on behalf of its stockholders, unless
a stockholder elects to receive cash. As a result, if the Board of Directors
authorizes, and the Company declares, a cash distribution, then its stockholders who
have not opted out of the dividend reinvestment plan will have their cash
distributions automatically reinvested in additional shares of common stock, rather
than receiving the cash distributions. On May 1, 2008, the Company declared a
dividend of $0.30 per share to stockholders of record on May 19, 2008. On June 3,
2008, the Company paid a cash dividend of approximately $1.9 million and issued
133,317 common shares totaling approximately $1.9 million under the dividend
reinvestment plan. On August 6, 2008, the Company declared a dividend of $0.31 per
share to stockholders of record on September 10, 2008. On September 26, 2008, the
Company paid a cash dividend of $5.1 million, and purchased and distributed a total
of 196,786 shares ($1.9 million) of its common stock under the dividend

23

FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

reinvestment plan. On December 9, 2008, the Company declared a dividend of $0.32 per
share to stockholders of record on December 19, 2008, and a $0.33 per share dividend
to stockholders of record on December 30, 2008. On December 18, 2008, the Company
declared a special dividend of $0.05 per share to stockholders of record on
December 30, 2008. On December 29, 2008, the Company paid a cash dividend of
approximately $6.4 million and issued 105,326 common shares totaling approximately
$0.8 million under the dividend reinvestment plan. On January 29, 2009, the Company
paid a cash dividend of approximately $7.6 million and issued 161,206 common shares
totaling approximately $1.0 million under the dividend reinvestment plan. On
April 14, 2009, the Company declared a dividend of $0.25 per share to stockholders of
record as of May 26, 2009. On June 25, 2009, the Company paid a cash dividend of
approximately $5.6 million and issued 11,776 common shares totaling approximately
$0.1 million under the dividend reinvestment plan. On August 3, 2009, the Company
declared a dividend of $0.25 per share to stockholders of record as of September 8,
2009. On September 25, 2009, the Company paid a cash dividend of approximately
$7.5 million and issued 56,890 common shares totaling approximately $0.6 million
under the dividend reinvestment plan. On November 21, 2009, the Company declared a
dividend of $0.27 per share to stockholders of record as of December 10, 2009. On
December 29, 2009, the Company paid a cash dividend of approximately $9.7 million and
issued 44,420 common shares totaling approximately $0.5 million under the dividend
reinvestment plan.

In October 2008, the Companys Board of Directors authorized a stock repurchase
program to acquire up to $8 million of the Companys outstanding common stock. Stock
repurchases under this program were made through the open market at times and in such
amounts as Company management deemed appropriate. The stock repurchase program
expired in December 2009. In October 2008, the Company repurchased 78,000 shares of
common stock on the open market as part of its share repurchase program.

Note 6. Line of Credit

On November 16, 2009, Fifth Street Funding, LLC, a wholly-owned bankruptcy
remote, special purpose subsidiary (Funding), and the Company entered into a Loan
and Servicing Agreement (Agreement), with respect to a three-year credit facility
(Facility) with Wachovia Bank, National Association (Wachovia), Wells Fargo
Securities, LLC, as administrative agent (Wells Fargo), each of the additional
institutional and conduit lenders party thereto from time to time, and each of the
lender agents party thereto from time to time, in the amount of $50 million with an
accordion feature, which allows for potential future expansion of the Facility up
to $100 million. The Facility is secured by all of the assets of Funding, and all of
the Companys equity interest in Funding. The Facility bears interest at LIBOR plus
4.00% per annum and has a maturity date of November 16, 2012. The Facility may be
extended for up to two additional years upon the mutual consent of Wells Fargo and
each of the lender parties thereto. The Company intends to use the net proceeds of
the Facility to fund a portion of its loan origination activities and for general
corporate purposes.

During the three months ended
December 31, 2009, the Company borrowed $38.0 million under
the Facility.
This amount remained outstanding at December 31, 2009.

In connection with the Facility, the Company concurrently entered into (i) a
Purchase and Sale Agreement with Funding, pursuant to which the Company will sell to
Funding certain loan assets it has originated or acquired, or will originate or
acquire and (ii) a Pledge Agreement with Wells Fargo Bank, National Association,
pursuant to which the Company pledged all of its equity interests in Funding as
security for the payment of Fundings obligations under the Agreement and other
documents entered into in connection with the Facility.

The Agreement and related agreements governing the Facility required both
Funding and the Company to, among other things (i) make representations and
warranties regarding the collateral as well as each of their businesses, (ii) agree
to certain indemnification obligations, and (iii) comply with various covenants,
servicing procedures, limitations on acquiring and disposing of assets, reporting
requirements and other customary requirements for similar credit facilities. The
Facility documents also included usual and customary default provisions such as the
failure to make timely payments under the Facility, a change in control of Funding,
and the failure by Funding or the Company to materially perform under the Agreement
and related agreements governing the Facility, which, if not complied with, could
accelerate repayment under the Facility, thereby materially and adversely affecting
the Companys liquidity, financial condition and results of operations.

24

FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

Each loan origination under the Facility is subject to the satisfaction of
certain conditions. The Company cannot assure you that Funding will be able to borrow
funds under the Facility at any particular time or at all.

On January 15, 2008, the Company entered into a $50 million secured revolving
credit facility with the Bank of Montreal, at a rate of LIBOR plus 1.5%, with a one
year maturity date. The credit facility was secured by the Companys existing
investments. On December 30, 2008, Bank of Montreal renewed the Companys $50 million
credit facility. The terms included a 50 basis points commitment fee, an interest
rate of LIBOR +3.25% and a term of 364 days. The Company gave notice of termination,
effective September 16, 2009, to Bank of Montreal with respect to this revolving
credit facility.

Prior to the merger of the Partnership with and into the Company, the
Partnership entered into a $50 million unsecured revolving line of credit with
Wachovia Bank, N.A. (Loan Agreement) which had a final maturity date of April 1,
2008. Borrowings under the Loan Agreement were at a variable interest rate of LIBOR
plus 0.75% per annum. In connection with the Loan Agreement, the General Partner, a
former member of the Board of Directors of Fifth Street Finance Corp. and an officer
of Fifth Street Finance Corp. (collectively guarantors), entered into a guaranty
agreement (the Guaranty) with the Partnership. Under the terms of the Guaranty, the
guarantors agreed to guarantee the Partnerships obligations under the Loan
Agreement. In consideration for the guaranty, the Partnership was obligated to pay a
former member of the Board of Directors of Fifth Street Finance Corp. a fee of
$41,667 per month so long as the Loan Agreement was in effect. For the period from
October 1, 2007 to November 27, 2007, the Partnership paid $83,333 under this
Guaranty. In October 2007, the Partnership drew $28.25 million under the Loan
Agreement. These loans were paid back in full with interest in November 2007. As of
November 27, 2007, the Partnership terminated the Loan Agreement and the Guaranty.

Interest expense for the three months ended December 31, 2009 and 2008 was
$91,179 and $40,158, respectively.

Note 7. Interest and Dividend Income

Interest income is recorded on the accrual basis to the extent that such amounts
are expected to be collected. In accordance with the Companys policy, accrued
interest is evaluated periodically for collectibility. The Company stops accruing
interest on investments when it is determined that interest is no longer collectible.
Distributions from portfolio companies are recorded as dividend income when the
distribution is received.

The Company holds debt in its portfolio that contains a payment-in-kind (PIK)
interest provision. The PIK interest, which represents contractually deferred
interest added to the loan balance that is generally due at the end of the loan term,
is generally recorded on the accrual basis to the extent such amounts are expected to
be collected. The Company generally ceases accruing PIK interest if there is
insufficient value to support the accrual or if the Company does not expect the
portfolio company to be able to pay all principal and interest due. The Companys
decision to cease accruing PIK interest involves subjective judgments and
determinations based on available information about a particular portfolio company,
including whether the portfolio company is current with respect to its payment of
principal and interest on its loans and debt securities; monthly and quarterly
financial statements and financial projections for the portfolio company; the
Companys assessment of the portfolio companys business development success,
including product development, profitability and the portfolio companys overall
adherence to its business plan; information obtained by the Company in connection
with periodic formal update interviews with the portfolio companys management and,
if appropriate, the private equity sponsor; and information about the general
economic and market conditions in which the portfolio company operates. Based on this
and other information, the Company determines whether to cease accruing PIK interest
on a loan or debt security. The Companys determination to cease accruing PIK
interest on a loan or debt security is generally made well before the Companys full
write-down of such loan or debt security.

25

FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

Accumulated PIK interest activity for the three months ended December 31, 2009
and December 31, 2008 was as follows:

Three months ended

Three months ended

December 31, 2009

December 31, 2008

PIK balance at beginning of period

$

12,059,478

$

5,367,032

Gross PIK interest accrued

2,430,657

2,021,186

PIK income reserves

(468,883

)

(204,401

)

PIK interest received in cash

(525,194

)

(120,434

)

Loan exits and other PIK adjustments

(530,061

)



PIK balance at end of period

$

12,965,997

$

7,063,383

Two investments did not pay all of their scheduled monthly cash interest
payments for the period ended December 31, 2009. As of December 31, 2009, the Company
had stopped accruing PIK interest and original issue discount (OID) on five
investments, including the two investments that had not paid all of their scheduled
monthly cash interest payments. As of December 31, 2008, the Company had stopped
accruing PIK interest and OID on three investments, including one investment that had
not paid all of its scheduled monthly cash interest payments.

Income non-accrual amounts for the three months ended December 31, 2009 and
December 31, 2008 were as follows:

Three months ended

Three months ended

December 31, 2009

December 31, 2008

Cash interest income

$

1,134,564

$

270,507

PIK interest income

468,883

204,401

OID income

103,911

97,350

Total

$

1,707,358

$

572,258

Note 8. Taxable/Distributable Income and Dividend Distributions

Taxable income differs from net increase (decrease) in net assets resulting from
operations primarily due to: (1) unrealized appreciation (depreciation) on
investments, as investment gains and losses are not included in taxable income until
they are realized; (2) origination fees received in connection with investments in
portfolio companies, which are amortized into interest income over the life of the
investment for book purposes, are treated as taxable income upon receipt;
(3) organizational and deferred offering costs; (4) recognition of interest income on
certain loans; and (5) income or loss recognition on exited investments.

At
December 31, 2009, the Company had a net loss carryforward of $1.5 million to
offset net capital gains, to the extent provided by federal tax law. The capital loss
carryforward will expire in the Companys tax year ending September 30, 2017.

26

FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

Listed below is a reconciliation of net increase in net assets resulting from
operations to taxable income for the three months ended December 31, 2009.

Net increase in net assets resulting from operations

$

9,454,000

Net change in unrealized appreciation from investments

(999,000

)

Book/tax difference due to deferred loan origination fees, net

3,974,000

Book/tax difference due to organizational and deferred offering costs

(22,000

)

Book/tax difference due to interest income on certain loans

787,000

Book/tax difference due to reduction of capital loss carryforward

(106,000

)

Other book-tax differences

78,000

Taxable/Distributable Income (1)

$

13,166,000

(1)

The Companys taxable income for 2010 is an estimate and will not be finally determined until the Company files its tax return for the fiscal year ended September 30, 2010. Therefore, the final taxable income may be different than the estimate.

The Company uses the asset and liability method to account for its taxable
subsidiaries income taxes. Using this method, the Company recognizes deferred tax
assets and liabilities for the estimated future tax effects attributable to temporary
differences between financial reporting and tax bases of assets and liabilities. In
addition, the Company recognizes deferred tax benefits associated with net operating
carry forwards that it may use to offset future tax obligations. The Company measures
deferred tax assets and liabilities using the enacted tax rates expected to apply to
taxable income in the years in which it expects to recover or settle those temporary
differences. The Company has recorded a deferred tax asset for the difference in the
book and tax basis of certain equity investments and tax net operating losses held by
its taxable subsidiaries of $1.7 million. However, this amount has been fully offset
by a valuation allowance of $1.7 million, since it is more likely than not that these
deferred tax assets will not be realized.

Distributions to stockholders are recorded on the declaration date. The Company
is required to distribute annually to its stockholders at least 90% of its net
ordinary income and net realized short-term capital gains in excess of net realized
long-term capital losses for each taxable year in order to be eligible for the tax
benefits allowed to a RIC under Subchapter M of the Code. The Company anticipates
paying out as a dividend all or substantially all of those amounts. The amount to be
paid out as a dividend is determined by the Board of Directors each quarter and is
based on managements estimate of the Companys annual taxable income. Based on that,
a dividend is declared and paid each quarter. The Company maintains an opt out
dividend reimbursement plan for its stockholders.

27

FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

To
date, the Companys Board of Directors declared, and the Company
paid, the following distributions:

Dividend Type

Date Declared

Record Date

Payment Date

Amount

Quarterly

5/1/2008

5/19/2008

6/3/2008

$

0.30

Quarterly

8/6/2008

9/10/2008

9/26/2008

$

0.31

Quarterly

12/9/2008

12/19/2008

12/29/2008

$

0.32

Quarterly

12/9/2008

12/30/2008

1/29/2009

$

0.33

Special

12/18/2008

12/30/2008

1/29/2009

$

0.05

Quarterly

4/14/2009

5/26/2009

6/25/2009

$

0.25

Quarterly

8/3/2009

9/8/2009

9/25/2009

$

0.25

Quarterly

11/12/2009

12/10/2009

12/29/2009

$

0.27

For income tax purposes, the Company estimates that these distributions will be
composed entirely of ordinary income, and will be reflected as such on the
Form 1099-DIV for the calendar year 2009. The Company anticipates declaring further
distributions to its stockholders to meet the RIC distribution requirements.

As a RIC, the Company is also subject to a
federal excise tax based on distributive requirements of its taxable income on a calendar year basis. As a result, the Company has accrued a
de minimis federal excise tax for calendar year 2009.

Note 9. Realized Gains or Losses from Investments and Net Change in Unrealized Appreciation or Depreciation from Investments

Realized gains or losses are measured by the difference between the net proceeds
from the sale or redemption and the cost basis of the investment without regard to
unrealized appreciation or depreciation previously recognized, and includes
investments written-off during the period, net of recoveries. Net change in
unrealized appreciation or depreciation from investments reflects the net change in
the valuation of the portfolio pursuant to the Companys valuation guidelines and the
reclassification of any prior period unrealized appreciation or depreciation on
exited investments.

During the three months ended December 31, 2009, the Company received a cash
payment in the amount of $0.1 million, representing a payment in full of all amounts
due in connection with the cancellation of its loan agreement with American Hardwoods
Industries, LLC. The Company recorded a $0.1 million reduction to the previously
recorded $10.4 million realized loss on this investment. During the three months
ended December 31, 2008, the Company recorded no realized gains or losses on
investments.

Note 10. Concentration of Credit Risks

The Company places its cash in financial institutions, and at times, such
balances may be in excess of the FDIC insured limit.

Note 11. Related Party Transactions

The Company has entered into an investment advisory agreement with the
Investment Adviser. Under the investment advisory agreement, the Company pays the
Investment Adviser a fee for its services under the investment advisory agreement
consisting of the following two components: a base management fee and an incentive fee.

Base
management Fee

The base management fee is calculated at an annual rate of 2% of the Companys
gross assets, which includes any borrowings for investment purposes. The base
management fee is payable quarterly in arrears, and will be calculated based on the
value of the Companys gross assets at the end of each fiscal quarter, and
appropriately adjusted on a pro rata basis for any equity capital raises or
repurchases during such quarter. The base management fee for any partial month or
quarter will be appropriately prorated.

28

FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

On
January 6, 2010, the Company announced that the Investment
Adviser
has voluntarily agreed to take the following actions:



To waive the portion of its base management fee for the quarter ended December 31, 2009 attributable to four new portfolio investments, as well as cash and cash equivalents. The amount of the management fee being waived is approximately $727,000; and



To permanently waive that portion of its base management fee attributable to the Companys assets held in the form of cash and cash equivalents as of the end of each quarter beginning March 31, 2010.

For purposes of the waiver, cash and cash equivalents is as defined in the notes to
the Companys Consolidated Financial Statements.

Prior to the merger of the Partnership with and into the Company, which occurred
on January 2, 2008, the Partnership paid the Investment Adviser a management fee (the
Management Fee), subject to the adjustments as described in the Partnership
Agreement, for investment advice equal to an annual rate of 2% of the aggregate
capital commitments of all limited partners (other than affiliated limited partners)
for each fiscal year (or portion thereof) provided, however, that commencing on the
earlier of (1) the first day of the fiscal quarter immediately following the
expiration of the commitment period, or (2) if a temporary suspension period became
permanent in accordance with the Partnership Agreement, on the first day of the
fiscal quarter immediately following the date of such permanent suspension, the
Management Fee for each subsequent twelve month period was equal to 1.75% of the NAV
of the Partnership (exclusive of the portion thereof attributable to the General
Partner and the affiliated limited partners, based upon respective capital
percentages).

For the three months ended December 31, 2009 and December 31, 2008, net base
management fees were approximately $1.5 million and $1.4 million, respectively.
At December 31, 2009, approximately $1.5 million was included in
base management fee payable on the Companys Consolidated Balance Sheet.

Incentive
Fee

The incentive fee portion of the investment advisory agreement has two parts.
The first part is calculated and payable quarterly in arrears based on the Companys
Pre-Incentive Fee Net Investment Income for the immediately preceding fiscal
quarter. For this purpose, Pre-Incentive Fee Net Investment Income means interest
income, dividend income and any other income (including any other fees (other than
fees for providing managerial assistance), such as commitment, origination,
structuring, diligence and consulting fees or other fees that the Company receives
from portfolio companies) accrued during the fiscal quarter, minus the Companys
operating expenses for the quarter (including the base management fee, expenses
payable under the Companys administration agreement with FSC, Inc., and any interest
expense and dividends paid on any issued and outstanding indebtedness or preferred
stock, but excluding the incentive fee). Pre-Incentive Fee Net Investment Income
includes, in the case of investments with a deferred interest feature (such as
original issue discount, debt instruments with PIK interest and zero coupon
securities), accrued income that the Company has not yet received in cash.
Pre-Incentive Fee Net Investment Income does not include any realized capital gains,
realized capital losses or unrealized capital appreciation or depreciation.
Pre-Incentive Fee Net Investment Income, expressed as a rate of return on the value
of the Companys net assets at the end of the immediately preceding fiscal quarter,
will be compared to a hurdle rate of 2% per quarter (8% annualized), subject to a
catch-up provision measured as of the end of each fiscal quarter. The Companys net
investment income used to calculate this part of the incentive fee is also included
in the amount of its gross assets used to calculate the 2% base management fee. The
operation of the incentive fee with respect to the Companys Pre-Incentive Fee Net
Investment Income for each quarter is as follows:



no incentive fee is payable to the Investment Adviser in any fiscal quarter in which the Companys Pre-Incentive Fee Net Investment Income does not exceed the hurdle rate of 2% (the preferred return or hurdle).



100% of the Companys Pre-Incentive Fee Net Investment Income with respect to that portion of such Pre-Incentive Fee Net Investment Income,
if any, that exceeds the hurdle rate but is less than or equal to 2.5% in any fiscal quarter (10% annualized) is payable to the Investment Adviser.
The Company refers to this portion of its Pre-Incentive Fee Net Investment Income (which exceeds the hurdle rate but is less than or equal to 2.5%)
as the catch-up. The catch-up provision is intended to provide the Investment Adviser with an incentive fee of 20% on all of the Companys
Pre-Incentive Fee Net Investment Income as if a hurdle rate did not apply when the Companys Pre-Incentive Fee Net Investment Income exceeds 2.5%
in any fiscal quarter.

29

FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



20% of the amount of the Companys Pre-Incentive Fee Net Investment Income, if any, that exceeds 2.5% in any fiscal quarter (10% annualized) is payable to the Investment Adviser once the hurdle is reached and the catch-up is achieved (20% of all Pre-Incentive Fee Net Investment Income thereafter is allocated to the Investment Adviser).

The second part of the incentive fee will be determined and payable in arrears
as of the end of each fiscal year (or upon termination of the investment advisory
agreement, as of the termination date), commencing on September 30, 2008, and will
equal 20% of the Companys realized capital gains, if any, on a cumulative basis from
inception through the end of each fiscal year, computed net of all realized capital
losses and unrealized capital depreciation on a cumulative basis, less the aggregate
amount of any previously paid capital gain incentive fees, provided that, the
incentive fee determined as of September 30, 2008 will be calculated for a period of
shorter than twelve calendar months to take into account any realized capital gains
computed net of all realized capital losses and unrealized capital depreciation from
inception.

For the three months ended December 31, 2009 and December 31, 2008, incentive
fees were approximately $2.1 million and $2.1 million, respectively.
At December 31, 2009, approximately $2.1 million was included in
incentive fee payable on the Companys Consolidated Balance Sheet.

Indemnification

The investment advisory agreement provides that, absent willful misfeasance, bad
faith or gross negligence in the performance of their respective duties or by reason
of the reckless disregard of their respective duties and obligations, the Companys
Investment Adviser and its officers, managers, agents, employees, controlling
persons, members (or their owners) and any other person or entity affiliated with it,
are entitled to indemnification from the Company for any damages, liabilities, costs
and expenses (including reasonable attorneys fees and amounts reasonably paid in
settlement) arising from the rendering of the Investment Advisers services under the
investment advisory agreement or otherwise as the Companys Investment Adviser.

Administration
Agreement

The Company has also entered into an administration agreement with FSC, Inc.
under which FSC, Inc. provides administrative services for the Company, including
office facilities and equipment, and clerical, bookkeeping and recordkeeping services
at such facilities. Under the administration agreement, FSC, Inc. also performs or
oversees the performance of the Companys required administrative services, which
includes being responsible for the financial records which the Company is required to
maintain and preparing reports to the Companys stockholders and reports filed with
the SEC. In addition, FSC, Inc. assists the Company in determining and publishing the
Companys net asset value, overseeing the preparation and filing of the Companys tax
returns and the printing and dissemination of reports to the Companys stockholders,
and generally overseeing the payment of the Companys expenses and the performance of
administrative and professional services rendered to the Company by others. For
providing these services, facilities and personnel, the Company reimburses FSC, Inc.
the allocable portion of overhead and other expenses incurred by FSC, Inc. in
performing its obligations under the administration agreement, including rent and the
Companys allocable portion of the costs of compensation and related expenses of the
Companys chief financial officer and his staff, and the staff of our chief
compliance officer. FSC, Inc. may also provide, on the Companys behalf, managerial
assistance to the Companys portfolio companies. The administration agreement may be
terminated by either party without penalty upon 60 days written notice to the other
party.

30

FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

For the three months ended December 31, 2009, the Company incurred
administrative expenses of approximately $0.4 million. At December 31, 2009,
approximately $728,000 was included in due to FSC, Inc. on the Companys Consolidated Balance
Sheet.

Note 12. Financial Highlights

Three

Three

months ended

months ended

Per share data (2):

December 31, 2009 (1)

December 31, 2008 (1)

Net asset value at beginning of period

$

10.84

$

13.02

Dividends declared

(0.27

)

(0.66

)

Issuance of common stock



(0.02

)

Repurchases of common stock



(0.02

)

Net investment income

0.22

0.36

Unrealized appreciation (depreciation) on investments

0.03

(0.82

)

Realized gain (loss) on investments





Net asset value at end of period

$

10.82

$

11.86

Stockholders equity at beginning of period

$

410,556,071

$

294,335,839

Stockholders equity at end of period

$

410,257,351

$

268,548,431

Average stockholders equity (3)

$

409,840,589

$

285,101,506

Ratio of
total expenses, excluding interest and line of credit guarantee expenses, to average stockholders equity (4)

The amounts reflected in the financial highlights above represent net assets, income and expense ratios for all stockholders.

(2)

Based on actual shares outstanding at the end of the corresponding period or weighted average shares outstanding for the period, as appropriate.

(3)

Calculated based upon the daily weighted average stockholders equity for the period.

(4)

Interim periods are not annualized.

(5)

Calculated based upon the daily weighted average of loans payable for the period.

31

FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

Note 13. Preferred Stock

The Companys restated certificate of incorporation had not authorized any
shares of preferred stock. However, on April 4, 2008, the Companys Board of
Directors approved a certificate of amendment to its restated
certificate of incorporation reclassifying 200,000 shares of its common stock as
shares of non-convertible, non-participating preferred stock, with a par value of
$0.01 and a liquidation preference of $500 per share (Series A Preferred Stock) and
authorizing the issuance of up to 200,000 shares of Series A Preferred Stock. The
Companys certificate of amendment was also approved by the holders of a majority of
the shares of its outstanding common stock through a written consent first solicited
on April 7, 2008. On April 24, 2008, the Company filed its certificate of amendment
and on April 25, 2008, it sold 30,000 shares of Series A Preferred Stock to a company
controlled by Bruce E. Toll, one of the Companys directors at that time. For the
three months ended June 30, 2008, the Company paid dividends of approximately
$234,000 on the 30,000 shares of Series A Preferred Stock. The dividend payment is
considered and included in interest expense for accounting purposes since the
preferred stock has a mandatory redemption feature. On June 30, 2008, the Company
redeemed 30,000 shares of Series A Preferred Stock at the mandatory redemption price
of 101% of the liquidation preference or $15,150,000. The $150,000 is considered and
included in interest expense for accounting purposes due to the stocks mandatory
redemption feature. No preferred stock is currently outstanding.

Note 14. Subsequent Events

On
January 6, 2010, the Company announced that the Investment Adviser
has voluntarily agreed to take the following actions:



To waive the portion of its base management fee for the quarter ended December 31, 2009 attributable to four new portfolio investments, as well as cash and cash equivalents. The amount of the management fee being waived is approximately $727,000; and



To permanently waive that portion of its base management fee attributable to the Companys assets held in the form of cash and cash equivalents as of the end of each quarter beginning March 31, 2010.

For purposes of the waiver, cash and cash equivalents is as defined in the notes to
the Companys Consolidated Financial Statements.

On January 6, 2010, the Company filed a preliminary proxy statement with the
Securities and Exchange Commission, or SEC, for its 2010 Annual Meeting of
Stockholders. Among other things, the Company plans to seek stockholder approval to
increase the number of authorized shares of its common stock and to remove its authority to issue shares of Series A Preferred Stock.
The Company also
announced that it does not intend to seek additional approval of its stockholders at
its 2010 Annual Meeting of Stockholders to sell or otherwise issue shares of its
common stock at a price below the then-current net asset value per share.

On January 6, 2010,
AmBath/ReBath Holdings, Inc. drew $0.8 million on its previously undrawn credit line.
Prior to the draw, the Companys unfunded commitment was $3.0
million.

On January 12, 2010, the Companys Board of Directors declared a distribution of
$0.30 per share, payable on March 30, 2010 to stockholders of record on March 3,
2010. In connection with the distribution declaration, the Company also announced
that as it originates more deals, the Company expects its quarterly distribution to
continue to increase during the fiscal year. The timing and amount of any
distribution is at the discretion of the Board of Directors.

On January 14, 2010, the Company provided a $2.5 million revolving credit line
to Vanguard Vinyl, Inc. (formerly known as Best Vinyl Acquisition Corporation), of
which $1.25 million was drawn at closing. This investment, along with the proceeds
from the sale of a non-core asset and an additional investment by the equity sponsor,
were utilized to pay off the companys existing senior debt. In connection with this
transaction, the Company received a first lien security interest on all of the assets
of the company. On January 21, 2010, Vanguard Vinyl, Inc. drew an additional $0.25
million on this credit line.

On January 15, 2010, the Company repaid $0.2 million of the outstanding balance on its secured
revolving credit facility with Wachovia. On January 28, 2010, the Company repaid $25.0 million of the
outstanding balance on the facility. On January 29, 2010, the Company repaid in full the outstanding balance of
$12.8 million on the facility.

On January 21, 2010, the Company announced that it had received a non-binding
term sheet from a lender in connection with a potential additional credit line of up
to $100 million. The term sheet is subject to completion of
due diligence and execution of definitive documents. The Company cannot assure
you that it will enter into any additional new financings.

On January 27, 2010, the Company completed a public offering of 7,000,000 shares of its common stock
at a price of $11.20 per share. The net proceeds totaled approximately $74.9 million after deducting investment
banking commissions of approximately $3.5 million.

On January 29, 2010, the Company
closed a $21.8 million senior secured debt facility to support the acquisition of a specialty food company.
The investment is backed by a private equity sponsor and $20.3 million was
funded at closing. The terms of this investment include a $1.5 million revolver
at an interest rate of 10% per annum, a $7.6 million Term Loan A at an interest
rate of 10% per annum, and a $12.7 million Term Loan B at an interest rate of 12% per
annum in cash and 3% PIK. This is a first lien facility with a
scheduled maturity of five years.

On February 1, 2010, TBA
Global, LLC repaid $2.5 million of principal outstanding under its Term Loan A.

On
February 3, 2010, the Companys wholly-owned subsidiary, Fifth Street
Mezzanine Partners IV, L.P., received a license, effective February 1, 2010, from the SBA
to operate as an SBIC under Section 301(c) of the Small Business Investment Act of
1958.

32

Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in connection with our consolidated financial
statements and the notes thereto included elsewhere in this quarterly report on Form 10-Q.

Some of the statements in this quarterly report on Form 10-Q constitute forward-looking
statements because they relate to future events or our future performance or financial condition.
The forward-looking statements contained in this quarterly report on Form 10-Q may include
statements as to:



our future operating results and dividend projections;



our business prospects and the prospects of our portfolio companies;



the impact of the investments that we expect to make;



the ability of our portfolio companies to achieve their objectives;



our expected financings and investments;



the adequacy of our cash resources and working capital; and



the timing of cash flows, if any, from the operations of our portfolio companies.

In addition, words such as anticipate, believe, expect and intend indicate a
forward-looking statement, although not all forward-looking statements include these words. The
forward-looking statements contained in this quarterly report on Form 10-Q involve risks and
uncertainties. Our actual results could differ materially from those implied or expressed in the
forward-looking statements for any reason, including the factors set forth in Risk Factors in our
annual report on Form 10-K for the year ended September 30, 2009 and elsewhere in this quarterly
report on Form 10-Q. Other factors that could cause actual results to differ materially include:



changes in the economy and the financial markets;



risks associated with possible disruption in our operations or the economy generally due to terrorism or natural disasters;



future changes in laws or regulations (including the interpretation of these laws and regulations by regulatory authorities) and conditions in our operating areas, particularly with respect to business development companies and RICs; and



other considerations that may be disclosed from time to time in our publicly disseminated documents and filings.

We have based the forward-looking statements included in this quarterly report on Form
10-Q on information available to us on the date of this quarterly report, and we assume no
obligation to update any such forward-looking statements. Although we undertake no obligation to
revise or update any forward-looking statements, whether as a result of new information, future
events or otherwise, you are advised to consult any additional disclosures that we may make
directly to you or through reports that we in the future may file with the Securities and Exchange
Commission, or the SEC, including annual reports on Form 10-K, quarterly reports on Form 10-Q and
current reports on Form 8-K.

We are a specialty finance company that lends to and invests in small and
mid-sized companies in connection with investments by private equity sponsors. Our
investment objective is to maximize our portfolios total return by generating
current income from our debt investments and capital appreciation from our equity
investments.

We were formed as a Delaware limited partnership (Fifth Street Mezzanine
Partners III, L.P.) on February 15, 2007. Effective as of January 2, 2008, Fifth
Street Mezzanine Partners III, L.P. merged with and into Fifth Street Finance Corp.
At the time of the merger, all outstanding partnership interests in Fifth Street
Mezzanine Partners III, L.P. were exchanged for 12,480,972 shares of common stock in
Fifth Street Finance Corp.

On June 17, 2008, we completed an initial public offering of
10,000,000 shares of our common stock at the offering price of $14.12 per share. Our
shares are currently listed on the New York Stock Exchange under the symbol FSC.

On July 21, 2009, we completed a follow-on public offering of
9,487,500 shares of our common stock, which included the underwriters exercise of
their over-allotment option, at the offering price of $9.25 per share.

On September 25, 2009, we completed a follow-on public offering of
5,520,000 shares of our common stock, which included the underwriters exercise of
their over-allotment option, at the offering price of $10.50 per share.

On January 27, 2010, we completed a follow-on public offering of
7,000,000 shares of our common stock, which did not include the underwriters exercise of
their over-allotment option, at the offering price of $11.20 per share.

Current Market Conditions

Since mid-2007, the financial services sector has been negatively impacted
by significant write-offs related to sub-prime mortgages and the re-pricing of credit
risk. Global debt and equity markets have suffered substantial stress, volatility,
illiquidity and disruption, with sub-prime mortgage-related issues being the most
significant contributing factor. These forces reached unprecedented levels by the
fall of 2008, resulting in the insolvency or acquisition of, or government assistance
to, several major domestic and international financial institutions.
While the severe stress in the financial markets appears to have
abated to a certain extent,
these past events
have significantly diminished overall confidence in the debt and equity markets and
continue to cause economic uncertainty. In particular, the disruptions in the financial markets increased the
spread between the yields realized on risk-free and higher risk securities, resulting
in illiquidity in parts of the financial markets. This widening of
spreads made it
more difficult for lower middle market companies to access capital as traditional
senior lenders became more selective, equity sponsors delayed transactions for better
earnings visibility, and sellers hesitated to accept lower purchase multiples. While the market for
corporate debt has improved of late, credit spreads have tightened and borrowing rates have trended
lower, reduced confidence and economic uncertainty could
further exacerbate overall market disruptions and risks to businesses in need of
capital.

Despite the economic uncertainty, our
deal pipeline remains robust, with high quality
transactions backed by private equity sponsors in the lower middle market. As always,
we remain cautious in selecting new investment opportunities, and will only deploy
capital in deals which are consistent with our disciplined philosophy of pursuing
superior risk-adjusted returns.

34

As
evidenced by our recent investment activities, we expect to grow the business in part by
increasing the average investment size when and where appropriate. At the same time,
we expect to focus more on first lien transactions. We also expect to invest in more
floating rate facilities, with rate floors, to protect against interest rate
decreases.

Although we believe that we currently have sufficient capital available to
fund investments, a prolonged period of market disruptions may cause us to reduce the
volume of loans we originate and/or fund, which could have an adverse effect on our
business, financial condition, and results of operations. Furthermore, because our
common stock has at times traded at a price below our current net asset value per
share over the last several months and we are not generally able under the 1940 Act
to sell our common stock at a price below net asset value per share, we may be
limited in our ability to raise equity capital.

Critical Accounting Policies

FASB Accounting Standards Codification

The issuance of FASB Accounting Standards Codification,tm or the Codification, on July 1, 2009 (effective for interim or
annual reporting periods ending after September 15, 2009), changes the way that
U.S. generally accepted accounting principles, or GAAP, are referenced. Beginning on
that date, the Codification officially became the single source of authoritative
nongovernmental GAAP; however, SEC registrants must also consider rules, regulations,
and interpretive guidance issued by the SEC or its staff. The switch affects the way
companies refer to U.S. GAAP in financial statements and in their accounting
policies. All existing standards that were used to create the Codification were
superseded by the Codification. Instead, references to standards will consist solely
of the number used in the Codifications structural organization. For example, it is
no longer proper to refer to FASB Statement No. 157, Fair Value Measurement , which
is now ASC Topic 820 Fair Value Measurements and Disclosures (ASC 820).

Consistent with the effective date of the Codification, financial
statements for periods ending after September 15, 2009, refer to the Codification
structure, not pre-Codification historical GAAP.

Basis of Presentation

Effective January 2, 2008, Fifth Street Mezzanine Partners III, L.P., or
the Partnership, a Delaware limited partnership organized on February 15, 2007,
merged with and into Fifth Street Finance Corp. The merger involved the exchange of
shares between companies under common control. In accordance with the guidance on
exchanges of shares between entities under common control, our results of operations
and cash flows for the fiscal year ended September 30, 2008 are presented as if the
merger had occurred as of October 1, 2007. Accordingly, no adjustments were made to
the carrying value of assets and liabilities (or the cost basis of investments) as a
result of the merger. Prior to January 2, 2008, references to Fifth Street are to the
Partnership. After January 2, 2008, references to Fifth Street, FSC, we or our
are to Fifth Street Finance Corp., unless the context otherwise requires. Fifth
Streets financial results for the fiscal year ended September 30, 2007 refer to the
Partnership.

The preparation of financial statements in accordance with GAAP requires
management to make certain estimates and assumptions affecting amounts reported in
the consolidated financial statements. We have identified investment valuation and
revenue recognition as our most critical accounting estimates. We continuously
evaluate our estimates, including those related to the matters described below. These
estimates are based on the information that is currently available to us and on
various other assumptions that we believe to be reasonable under the circumstances.
Actual results could differ materially from those estimates under different
assumptions or conditions. A discussion of our critical accounting policies follows.

35

Investment Valuation

We are required to report our investments that are not publicly traded or
for which current market values are not readily available at fair value. The fair
value is deemed to be the value at which an enterprise could be sold in a transaction
between two willing parties other than through a forced or liquidation sale.

Under ASC 820, which we adopted effective October 1, 2008, we perform
detailed valuations of our debt and equity investments on an individual basis, using
market based, income based, and bond yield approaches as appropriate.

Under the market approach, we estimate the enterprise value of the
portfolio companies in which we invest. There is no one methodology to estimate
enterprise value and, in fact, for any one portfolio company, enterprise value is
best expressed as a range of fair values, from which we derive a single estimate of
enterprise value. To estimate the enterprise value of a portfolio company, we analyze
various factors, including the portfolio companys historical and projected financial
results. Typically, private companies are valued based on multiples of EBITDA, cash
flows, net income, revenues, or in limited cases, book value. We generally require
portfolio companies to provide annual audited and quarterly and monthly unaudited
financial statements, as well as annual projections for the upcoming fiscal year.

Under the income approach, we generally prepare and analyze discounted cash
flow models based on our projections of the future free cash flows of the business.
Under the bond yield approach, we use bond yield models to determine the present
value of the future cash flow streams of our debt investments. We review various
sources of transactional data, including private mergers and acquisitions involving
debt investments with similar characteristics, and assess the information in the
valuation process.

We also may, when conditions warrant, utilize an expected recovery model,
whereby we use alternate procedures to determine value when the customary approaches
are deemed to be not as relevant or reliable.

Our Board of Directors undertakes a multi-step valuation process each
quarter in connection with determining the fair value of our investments:



Our quarterly valuation process begins with each portfolio company or investment being initially
valued by the deal team within our investment adviser responsible for the portfolio investment;



Preliminary valuations are then reviewed and discussed with the principals of our investment adviser;



Separately, an independent valuation firm engaged by the Board of Directors prepares preliminary
valuations on a selected basis and submits a report to us;



The deal team compares and contrasts its preliminary valuations to the report of the independent
valuation firm and resolves any differences;



The deal team prepares a final valuation report for the Valuation Committee of our Board of Directors;



The Valuation Committee of our Board of Directors reviews the preliminary valuations, and the deal
team responds and supplements the preliminary valuations to reflect any comments provided by the
Valuation Committee;



The Valuation Committee of our Board of Directors makes a recommendation to the Board of Directors; and



The Board of Directors discusses valuations and determines the fair value of each investment in our
portfolio in good faith.

The fair value of all of our investments at December 31, 2009 and
September 30, 2009 was determined by our Board of Directors. Our Board of Directors
is solely responsible for the valuation of our portfolio investments at fair value as
determined in good faith pursuant to our valuation policy and our consistently
applied valuation process.

36

Our Board of Directors has engaged an independent valuation firm to provide
us with valuation assistance. Upon completion of its process each quarter, the independent valuation firm
provides us with a written report regarding the preliminary valuations of selected
portfolio securities as of the close of such quarter. We will continue to engage an
independent valuation firm to provide us with assistance regarding our determination
of the fair value of selected portfolio securities each quarter; however, our Board of Directors is
ultimately and solely responsible for determining the fair value of our investments
in good faith.

An independent valuation firm, Murray, Devine & Co., Inc., provided us with
assistance in our determination of the fair value of 91.9% of our portfolio for the
quarter ended December 31, 2007, 92.1% of our portfolio for the quarter ended
March 31, 2008, 91.7% of our portfolio for the quarter ended June 30, 2008, 92.8% of
our portfolio for the quarter ended September 30, 2008, 100% of our portfolio for the
quarter ended December 31, 2008, 88.7% of our portfolio for the quarter ended
March 31, 2009 (or 96% of our portfolio excluding our investment in IZI Medical
Products, Inc., which closed on March 31, 2009 and therefore was not part of the
independent valuation process), 92.1% of our portfolio for the quarter ended June 30,
2009, 28.1% of our portfolio for the quarter ended September 30, 2009, and 17.2% of
our portfolio for the quarter ended December 31, 2009
(or 24.8% of our portfolio excluding the four investments that closed in late December and therefore were not part
of the independent valuation process).

Our $50 million credit facility with Bank of Montreal was terminated effective
September 16, 2009. The facility required independent valuations for at least 90% of
the portfolio on a quarterly basis. With the termination of this facility, this
valuation test is no longer required. However, we still intend to have a portion of
the portfolio valued by an independent third party on a quarterly basis, with a
substantial portion being valued on an annual basis.

As of December 31, 2009 and September 30, 2009, approximately 96.4% and
72.0%, respectively, of our total assets represented investments in portfolio
companies valued at fair value.

Effective October 1, 2008, we adopted ASC 820. In accordance with that
standard, we changed our presentation for all periods presented to net unearned fees
against the associated debt investments. Prior to the adoption of ASC 820 on
October 1, 2008, we reported unearned fees as a single line item on our Consolidated
Balance Sheets and Consolidated Schedule of Investments. This change in presentation
had no impact on the overall net cost or fair value of our investment portfolio and
had no impact on our financial position or results of operations.

Revenue Recognition

Interest and Distribution Income

Interest income, adjusted for amortization of premium and accretion of
original issue discount, is recorded on the accrual basis to the extent that such
amounts are expected to be collected. We stop accruing interest on investments when
it is determined that interest is no longer collectible. Distributions from portfolio
companies are recorded as distribution income when the distribution is received.

Fee Income

We receive a variety of fees in the ordinary course of our business,
including origination fees. We account for our fee income in accordance with ASC
Topic 605-25 Multiple-Element Arrangements (ASC 605-25), which addresses certain
aspects of a companys accounting for arrangements containing multiple
revenue-generating activities. In some arrangements, the different revenue-generating
activities (deliverables) are sufficiently separable and there exists sufficient
evidence of their fair values to separately account for some or all of the
deliverables (i.e., there are separate units of accounting). ASC 605-25 states that
the total consideration received for the arrangement

37

be allocated to each unit based upon each units relative fair value. In other
arrangements, some or all of the deliverables are not independently functional, or
there is not sufficient evidence of their fair values to account for them separately.
The timing of revenue recognition for a given unit of accounting depends on the
nature of the deliverable(s) in that accounting unit (and the corresponding revenue
recognition model) and whether the general conditions for revenue recognition have
been met. Fee income for which fair value cannot be reasonably ascertained is
recognized using the interest method in accordance with ASC 310-20 Nonrefundable Fees
and Other Costs.

As of December 31, 2009, we were entitled to receive approximately
$7.8 million in aggregate exit fees across 12 portfolio investments upon the future
exit of those investments. These fees will typically be paid to us upon the sooner to
occur of (i) a sale of the borrower or substantially all of the assets of the
borrower, (ii) the maturity date of the loan, or (iii) the date when full prepayment
of the loan occurs. Exit fees, which are contractually payable by borrowers to us,
previously were to be recognized by us on a cash basis when received and not accrued
or otherwise included in net investment income until received. None of the loans with
exit fees, all of which were originated in 2008 and 2009, have been exited and, as a
result, no exit fees were recognized. Beginning with the quarter ended December 31,
2009, we recognize income pertaining to contractual exit fees on an accrual
basis and add exit fee income to the principal balance of the related loan to the
extent we determine that collection of the exit fee income is probable. Additionally,
we include the cash flows of contractual exit fees that we determine are
probable of collection in determining the fair value of our loans. We believe the effect of
this cumulative adjustment in the quarter ended December 31, 2009 is not material to
our financial statements as of any date or for any period.

Our decision to accrue exit fees and the amount of each accrual involves subjective judgments and determinations by us based on the risks and
uncertainties associated with our ability to ultimately collect exit fees relating to
each individual loan, including the actions of the senior note holders to block the
payment of the exit fees, our relationship with the equity sponsor, the potential
modification and extension of a loan, and consideration of situations where exit fees
have been added after the initial investment as a remedy for a
covenant violation.

Payment-in-Kind (PIK) Interest

Our loans typically contain a contractual PIK interest provision. The PIK
interest, which represents contractually deferred interest added to the loan balance
that is generally due at the end of the loan term, is generally recorded on the
accrual basis to the extent such amounts are expected to be collected. We generally
cease accruing PIK interest if there is insufficient value to support the accrual or
if we do not expect the portfolio company to be able to pay all principal and
interest due. Our decision to cease accruing PIK interest involves subjective
judgments and determinations based on available information about a particular
portfolio company, including whether the portfolio company is current with respect to
its payment of principal and interest on its loans and debt securities; monthly and
quarterly financial statements and financial projections for the portfolio company;
our assessment of the portfolio companys business development success, including
product development, profitability and the portfolio companys overall adherence to
its business plan; information obtained by us in connection with periodic formal
update interviews with the portfolio companys management and, if appropriate, the
private equity sponsor; and information about the general economic and market
conditions in which the portfolio company operates. Based on this and other
information, we determine whether to cease accruing PIK interest on a loan or debt
security. Our determination to cease accruing PIK interest on a loan or debt security
is generally made well before our full write-down of such loan or debt security. In
addition, if it is subsequently determined that we will not be able

38

to collect any previously accrued PIK interest, the fair value of our loans or debt
securities would decline by the amount of such previously accrued, but uncollectible,
PIK interest.

To maintain our status as a RIC, PIK income must be paid out to our
stockholders in the form of dividends even though we have not yet collected the cash
and may never collect the cash relating to the PIK interest. Accumulated PIK interest
was approximately $13.0 million and represented 3% of the fair value of our portfolio
of investments as of December 31, 2009 and approximately $12.1 million or 4% as of
September 30, 2009. The net increase in loan balances as a result of contracted PIK
arrangements are separately identified in our Consolidated Statements of Cash Flows.

Portfolio Composition

Our investments principally consist of loans, purchased equity investments
and equity grants in privately-held companies. Our loans are typically secured by
either a first or second lien on the assets of the portfolio company, generally have
terms of up to six years (but an expected average life of between three and four
years) and typically bear interest at fixed rates and, to a lesser extent, at floating
rates. We are currently focusing our new debt origination efforts on first lien
loans.

A summary of the composition of our investment portfolio at cost and fair
value as a percentage of total investments is shown in the following tables:

December 31,

September 30,

2009

2009

Cost:

First lien debt

62.66

%

46.82

%

Second lien debt

35.11

%

50.08

%

Purchased equity

0.90

%

1.27

%

Equity grants

1.29

%

1.83

%

Limited partnership interests

0.04

%

0.00

%

Total

100.00

%

100.00

%

December 31,

September 30,

2009

2009

Fair value:

First lien debt

64.29

%

47.40

%

Second lien debt

34.87

%

51.37

%

Purchased equity

0.08

%

0.17

%

Equity grants

0.73

%

1.06

%

Limited partnership interests

0.03

%

0.00

%

Total

100.00

%

100.00

%

39

The industry composition of our portfolio at cost and fair value were as
follows:

December 31,

September 30,

2009

2009

Cost:

Healthcare services

10.88

%

15.53

%

Healthcare equipment

9.77

%

0.00

%

Healthcare technology

7.99

%

11.37

%

Home improvement retail

6.70

%

0.00

%

Education services

6.48

%

0.00

%

Fertilizers & agricultural chemicals

5.89

%

0.00

%

Footwear and apparel

4.90

%

6.85

%

Construction and engineering

4.19

%

5.89

%

Emulsions manufacturing

3.75

%

3.59

%

Trailer leasing services

3.68

%

5.21

%

Restaurants

3.57

%

6.20

%

Manufacturing  mechanical products

3.30

%

4.71

%

Media  Advertising

2.93

%

4.10

%

Data processing and outsourced services

2.89

%

4.12

%

Merchandise display

2.83

%

3.98

%

Home furnishing retail

2.79

%

3.93

%

Housewares & specialties

2.60

%

3.68

%

Air freight and logistics

2.35

%

3.29

%

Capital goods

2.17

%

3.05

%

Food distributors

1.94

%

2.73

%

Environmental & facilities services

1.93

%

2.73

%

Entertainment  theaters

1.71

%

2.32

%

Household products/ specialty chemicals

1.68

%

2.38

%

Leisure facilities

1.53

%

2.20

%

Building products

1.52

%

2.14

%

Multi-sector holdings

0.03

%

0.00

%

Total

100.00

%

100.00

%

December 31,

September 30,

2009

2009

Fair value:

Healthcare services

11.75

%

17.21

%

Healthcare equipment

10.37

%

0.00

%

Healthcare technology

8.40

%

12.27

%

Home improvement retail

7.10

%

0.00

%

Education services

6.87

%

0.00

%

Fertilizers & agricultural chemicals

6.25

%

0.00

%

Footwear and apparel

5.13

%

7.37

%

Emulsions manufacturing

4.13

%

4.05

%

Construction and engineering

4.13

%

5.96

%

Manufacturing  mechanical products

3.41

%

5.03

%

Restaurants

3.29

%

5.94

%

Media  Advertising

3.01

%

4.37

%

Data processing and outsourced services

3.01

%

4.44

%

Merchandise display

2.96

%

4.36

%

Air freight and logistics

2.54

%

3.60

%

Home furnishing retail

2.33

%

3.45

%

Capital goods

2.23

%

3.26

%

Trailer leasing services

2.07

%

3.29

%

Food distributors

2.03

%

3.00

%

Entertainment  theaters

1.80

%

2.52

%

Housewares & specialties

1.76

%

1.90

%

Leisure facilities

1.63

%

2.38

%

Building products

1.42

%

2.06

%

Environmental & facilities services

1.30

%

2.04

%

Household products/ specialty chemicals

1.04

%

1.50

%

Multi-sector holdings

0.04

%

0.00

%

Total

100.00

%

100.00

%

40

Portfolio Asset Quality

We employ a grading system to assess and monitor the credit risk of our
loan portfolio. We rate all loans on a scale from 1 to 5. The system is intended to
reflect the performance of the borrowers business, the collateral coverage of the
loan, and other factors considered relevant to making a credit judgment.



Investment Rating 1 is used for investments that are
performing above expectations and/or a capital gain is
expected.



Investment Rating 2 is used for investments that are
performing substantially within our expectations, and
whose risks remain neutral or favorable compared to the
potential risk at the time of the original investment. All
new loans are initially rated 2.



Investment Rating 3 is used for investments that are
performing below our expectations and that require closer
monitoring, but where we expect no loss of investment
return (interest and/or dividends) or principal. Companies
with a rating of 3 may be out of compliance with financial
covenants.



Investment Rating 4 is used for investments that are
performing below our expectations and for which risk has
increased materially since the original investment. We
expect some loss of investment return, but no loss of
principal.



Investment Rating 5 is used for investments that are
performing substantially below our expectations and whose
risks have increased substantially since the original
investment. Investments with a rating of 5 are those for
which some loss of principal is expected.

The following table shows the distribution of our investments on the 1 to 5
investment rating scale at fair value, as of December 31, 2009 and September 30,
2009:

December 31, 2009

September 30, 2009

% of

Leverage

% of

Leverage

Investment Rating

Fair Value

Portfolio

ratio

Fair Value

Portfolio

ratio

1

$

28,580,468

6.54

%

1.88

$

22,913,497

7.65

%

1.70

2

379,016,983

86.79

%

4.24

248,506,393

82.94

%

4.34

3

5,685,262

1.30

%

12.87

6,122,236

2.04

%

10.04

4

15,726,498

3.60

%

7.73

16,377,904

5.47

%

8.31

5

7,684,329

1.77

%

NM

(1)

5,691,107

1.90

%

NM

(1)

Total

$

436,693,540

100.00

%

4.05

$

299,611,137

100.00

%

4.42

(1)

Due to operating performance this ratio is not measurable.

As a result of current economic conditions and their impact on certain of
our portfolio companies, we have agreed to modify the payment terms of our
investments in nine of our portfolio companies as of December 31, 2009. Such modified
terms include increased PIK interest provisions and reduced cash interest rates.
These modifications, and any future modifications to our loan agreements as a result
of the current economic conditions or otherwise, may limit the amount of interest
income that we recognize from the modified investments, which may, in turn, limit our
ability to make distributions to our stockholders.

Loans and Debt Securities on Non-Accrual Status

As of December 31, 2009, we had stopped accruing PIK interest and original
issue discount (OID) on five investments, including two investments that had not
paid their scheduled monthly cash interest payments. As of December 31, 2008, we had
stopped accruing PIK interest and OID on three investments, including one investment
that had not paid its scheduled monthly cash interest payments.

Income non-accrual amounts for the three months ended December 31, 2009 and
December 31, 2008 were as follows:

Three months ended

Three months ended

December 31, 2009

December 31, 2008

Cash interest income

$

1,134,564

$

270,507

PIK interest income

468,883

204,401

OID income

103,911

97,350

Total

$

1,707,358

$

572,258

41

Discussion and Analysis of Results and Operations

Results of Operations

The principal measure of our financial performance is the net income (loss)
which includes net investment income (loss), net realized gain (loss) and net
unrealized appreciation (depreciation). Net investment income is the difference
between our income from interest, dividends, fees, and other investment income and
total expenses. Net realized gain (loss) on investments is the difference between the
proceeds received from dispositions of portfolio investments and their stated costs.
Net unrealized appreciation (depreciation) on investments is the net change in the
fair value of our investment portfolio.

Comparison of the three months ended December 31, 2009 and December 31, 2008

Total Investment Income

Total investment income includes interest and dividend income on our
investments, fee income and other investment income. Fee income consists principally
of loan and arrangement fees, annual administrative fees, unused fees, prepayment
fees, amendment fees, equity structuring fees, exit fees and waiver fees. Other
investment income consists primarily of dividend income received from certain of our
equity investments and interest on cash and cash equivalents on deposit with
financial institutions.

Total investment income for the three months ended December 31, 2009 and
December 31, 2008 was approximately $13.2 million and $12.6 million, respectively.
For the three months ended December 31, 2009, this amount primarily consisted of
approximately $12.1 million of interest income from portfolio investments (which
included approximately $2.0 million of PIK interest), and $0.9 million of fee income.
For the three months ended December 31, 2009, fee income included
approximately $27,000 of income from accrued exit fees.
For the three months ended December 31, 2008, total investment income primarily consisted of
approximately $11.4 million of interest income from portfolio investments (which
included approximately $1.8 million of PIK interest), and $1.1 million of fee income.
No exit fee income was recognized during the three months ended
December 31, 2008.

The
increase in our total investment income for the three months ended
December 31, 2009 as compared to the three months ended December 31, 2008 was
primarily attributable to higher average levels of outstanding debt investments,
which was principally due to an increase of seven investments in our portfolio in the
year-over-year period, partially offset by debt repayments received during the same
period.

Expenses

Expenses (net of the waived portion of the base management fee) for the
three months ended December 31, 2009 and December 31, 2008 were approximately
$4.9 million and $4.4 million, respectively. Expenses increased for the three months
ended December 31, 2009 as compared to the three months ended December 31, 2008 by
approximately $0.5 million, primarily as a result of increases
in the base management
fee, the incentive fee and other general and administrative expenses.

The
increase in the base management fee resulted from an increase in our total
assets as reflected in the growth of the investment portfolio offset partially by our
investment advisers unilateral decision to waive approximately $727,000 of the base
management fee for the three months ended December 31, 2009. Incentive fees were
implemented effective January 2, 2008 when Fifth Street Mezzanine Partners III, L.P.
merged with and into Fifth Street Finance Corp., and reflect the growth of our net
investment income before such fees.

Net Investment Income

As a result of the $0.6 million increase in total investment income as
compared to the $0.5 million increase in total expenses, net investment income for
the three months ended December 31, 2009 reflected a $0.1 million, or 1.7%, increase
compared to the three months ended December 31, 2008.

Realized Gain (Loss) on Sale of Investments

Net realized gain (loss) on the sale of investments is the difference
between the proceeds received from dispositions of portfolio investments and their
stated costs. During the three months ended December 31, 2009, we received a cash
payment in the amount of $0.1 million, representing a payment in full of all amounts
due in connection with the cancellation of our loan agreement with American Hardwoods
Industries, LLC. We recorded a $0.1 million reduction to the previously recorded
$10.4 million realized loss on this investment. During the three months ended
December 31, 2008, we recorded no realized gains or losses on investments.

42

Net Change in Unrealized Appreciation or Depreciation on Investments

Net unrealized appreciation or depreciation on investments is the net
change in the fair value of our investment portfolio during the reporting period,
including the reversal of previously recorded unrealized appreciation or depreciation
when gains or losses are realized. During the three months ended December 31, 2009,
we recorded net unrealized appreciation of $1.0 million. This consisted of
$1.2 million of net unrealized appreciation on debt investments, partially offset by
$0.2 million of net unrealized depreciation on equity investments. During the three
months ended December 31, 2008, we recorded net unrealized depreciation of
$18.5 million. This consisted of $16.7 million of net unrealized depreciation on debt
investments and $1.8 million of net unrealized depreciation on equity investments.

Financial Condition, Liquidity and Capital Resources

Cash Flows

To fund growth, we have a number of alternatives available to increase
capital, including, but not limited to, raising equity, increasing debt, or funding
from operational cash flow. Additionally, we may reduce investment size by
syndicating a portion of any given transaction.

For the three months ended December 31, 2009, we experienced a net decrease
in cash and cash equivalents of $101.4 million. During that period, we used
$129.4 million of cash in operating activities, primarily for the funding of
$144.2 million of investments, partially offset by $5.9 million of principal payments
received and $8.3 million of net investment income. During the same period cash
provided by financing activities was $28.0 million, primarily consisting of $38.0 million of net
borrowings on our credit facility partially offset by $9.7 million of cash
distributions paid. We intend to fund our future distribution obligations through
operating cash flow or with funds obtained through future equity offerings or credit
lines, as we deem appropriate.

For the three months ended December 31, 2008, we experienced a net decrease
in cash and equivalents of $15.7 million. During that period, we used $8.5 million of
cash in operating activities, primarily for the funding of $23.7 million of
investments, partially offset by $9.7 million of principal payments received and
$8.2 million of net investment income. During the same period cash used by financing
activities was $7.2 million, primarily consisting of $6.4 million of cash
distributions paid and $0.5 million paid to repurchase shares of our common stock on
the open market.

As of December 31, 2009, we had $11.8 million in cash and cash equivalents,
portfolio investments (at fair value) of $436.7 million,
$3.4 million of interest and fees
receivable, $38.0 million of borrowings outstanding under our secured credit facility and unfunded commitments of $32.1 million. As of January 31, 2010, we
had $28.6 million in cash and cash equivalents, $5.0 million of
interest and fees receivable,
no borrowings outstanding under our secured credit facility and
unfunded commitments of $33.8 million.

As of September 30, 2009, we had $113.2 million in cash and cash
equivalents, portfolio investments (at fair value) of $299.6 million, $2.9 million of
interest receivable, no borrowings outstanding and unfunded commitments of
$9.8 million.

Significant capital transactions that occurred from Inception through December
31, 2009

On March 30, 2007, we closed on approximately $78 million in capital
commitments from the sale of limited partnership interests of Fifth Street Mezzanine
Partners III, L.P. As of September 30, 2007, we had closed on additional capital
commitments, bringing the total amount of capital commitments to approximately
$165 million. We then closed on capital commitments from the sale of additional
limited partnership interests of Fifth Street Mezzanine Partners III, L.P., bringing
the total amount of capital commitments to $169.4 million as of November 28, 2007.

On January 2, 2008, Fifth Street Mezzanine Partners III, L.P. merged with
and into Fifth Street Finance Corp. At the time of the merger, all outstanding
partnership interests in Fifth Street Mezzanine Partners III, L.P. were exchanged for
12,480,972 shares of common stock of Fifth Street Finance Corp.

On January 15, 2008, we entered into a $50.0 million secured revolving
credit facility with the Bank of
Montreal, at a rate of LIBOR plus 1.5% per annum, with a one year maturity date.
The credit facility was secured by our existing investments.

43

On April 25, 2008, we sold 30,000 shares of non-convertible,
non-participating preferred stock, with a par value of $0.01 and a liquidation
preference of $500 per share, or Series A Preferred Stock, at a price of $500 per
share to a company controlled by Bruce E. Toll, one of our directors at that time,
for total proceeds of $15 million. For the three months ended June 30, 2008, we paid
distributions of approximately $234,000 on the 30,000 shares of Series A Preferred
Stock. The distribution payment is considered and included in interest expense for
accounting purposes since the preferred stock has a mandatory redemption feature. On
June 30, 2008, we redeemed 30,000 shares outstanding of our Series A Preferred Stock
at the mandatory redemption price of 101% of the liquidation preference, or
$15,150,000. The $150,000 is considered and included in interest expense for
accounting purposes due to the stocks mandatory redemption feature.

On May 1, 2008, our Board of Directors declared a distribution of $0.30 per
share of common stock payable to stockholders of record as of May 19, 2008. On
June 3, 2008, we paid a cash distribution of $1.9 million and issued 133,316 shares
of common stock totaling $1.9 million to those stockholders who did not opt out of
reinvesting the distribution under our dividend reinvestment plan.

On June 17, 2008, we completed an initial public offering of
10,000,000 shares of our common stock at the offering price of $14.12 per share and
received gross proceeds of approximately $141.2 million.

On August 6, 2008, our Board of Directors declared a distribution of $0.31
per share of common stock payable to stockholders of record as of September 10, 2008.
On September 26, 2008, we paid a cash distribution of $5.1 million and purchased
196,786 shares of common stock totaling $1.9 million on the open market to satisfy
the share obligations under the dividend reinvestment plan.

In October 2008, we repurchased 78,000 shares of our common stock on the
open market as part of our share repurchase program following its announcement on
October 15, 2008.

On December 9, 2008, our Board of Directors declared a distribution of
$0.32 per share of common stock payable to stockholders of record as of December 19,
2008 and a distribution of $0.33 per share of common stock payable to stockholders of
record as of December 30, 2008. On December 18, 2008, our Board of Directors declared
a special distribution of $0.05 per share of common stock payable to stockholders of
record as of December 30, 2008. On December 29, 2008, we paid a cash distribution of
$6.4 million and issued 105,326 shares of common stock totaling $0.8 million under
the dividend reinvestment plan. On January 29, 2009, we paid a cash distribution of
$7.6 million and issued 161,206 shares of common stock totaling $1.0 million under
the dividend reinvestment plan.

On December 30, 2008, Bank of Montreal approved a renewal of our
$50 million credit facility. The terms included a 50 basis points commitment fee, an
interest rate of LIBOR plus 3.25% per annum and a term of 364 days.

On April 14, 2009, our Board of Directors declared a distribution of $0.25
per share of common stock payable to stockholders of record as of May 26, 2009. On
June 25, 2009, we paid a cash distribution of $5.6 million and issued 11,776 shares
of common stock totaling $0.1 million under the dividend reinvestment plan.

On July 21, 2009, we completed a public offering of 9,487,500 shares of
common stock, which included the underwriters full exercise of their option to
purchase up to 1,237,500 shares of common stock, at a price of $9.25 per share,
raising approximately $87.8 million in gross proceeds.

On August 3, 2009, our Board of Directors declared a distribution of $0.25
per share of common stock payable to stockholders of record as of September 8, 2009.
On September 25, 2009, we paid a cash distribution of $7.5 million and issued
56,890 shares of common stock totaling $0.6 million under the dividend reinvestment
plan.

On September 16, 2009, we gave notice of termination to Bank of Montreal
with respect to our $50 million credit facility.

On September 25, 2009, we completed a public offering of 5,520,000 shares
of common stock, which included the underwriters full exercise of their option to
purchase up to 720,000 shares of common stock, at a price of $10.50 per share,
raising approximately $58.0 million in gross proceeds.

On November 12, 2009, our Board of Directors declared a distribution of $0.27
per share of common stock
payable to stockholders of record as of December 10, 2009. On December 30, 2009,
we paid a cash distribution of $9.7 million and issued 44,420 shares of common stock
totaling $0.5 million under the dividend reinvestment plan.

On November 16, 2009, we entered into a three-year credit facility with
Wachovia in the amount of $50 million with an accordion feature, which allows for
potential future expansion of the facility up to $100 million,
and bears interest at LIBOR plus 4% per annum. During the three months ended
December 31, 2009, we borrowed $38.0 million under this credit facility. This amount
remained outstanding at December 31, 2009.

44

Other Sources of Liquidity

We intend to continue to generate cash primarily from cash flows from
operations, including interest earned from the temporary investment of cash in
U.S. government securities and other high-quality debt investments that mature in one
year or less, future borrowings and future offerings of securities. In the future, we
may also securitize a portion of our investments in first and second lien senior
loans or unsecured debt or other assets. To securitize loans, we would likely create
a wholly owned subsidiary and contribute a pool of loans to the subsidiary. We would
then sell interests in the subsidiary on a non-recourse basis to purchasers and we
would retain all or a portion of the equity in the subsidiary. Our primary use of
funds is investments in our targeted asset classes and cash distributions to holders
of our common stock.

Although we expect to fund the growth of our investment portfolio through
the net proceeds from future equity offerings, including our dividend reinvestment
plan, and issuances of senior securities or future borrowings, to the extent
permitted by the 1940 Act, our plans to raise capital may not be successful. In this
regard, because our common stock has at times traded at a price below our current net asset
value per share and we are limited in our ability to
sell our common stock at a price below net asset value per share, we may be limited
in our ability to raise equity capital. Our stockholders approved a proposal at a
special meeting of stockholders held on June 24, 2009 that authorizes us to sell
shares of our common stock below the then-current net asset value per share in one or
more offerings for a period ending on the earlier of June 24, 2010 or the date of our
next annual meeting of stockholders. We do not intend to seek the approval of our
stockholders at the 2010 Annual Meeting of Stockholders to sell or otherwise issue
shares of our common stock at a price below the then-current net asset value per
share.

In addition, we intend to distribute between 90% and 100% of our taxable
income to our stockholders in order to satisfy the requirements applicable to RICs
under Subchapter M of the Code. See Regulated Investment Company Status and
Distributions below. Consequently, we may not have the funds or the ability to fund
new investments, to make additional investments in our portfolio companies, to fund
our unfunded commitments to portfolio companies or to repay borrowings under our
credit facility. In addition, the illiquidity of our portfolio investments may make
it difficult for us to sell these investments when desired and, if we are required to
sell these investments, we may realize significantly less than their recorded value.

Also, as a business development company, we generally are required to meet
a coverage ratio of total assets, less liabilities and indebtedness not represented
by senior securities, to total senior securities, which include all of our borrowings
and any outstanding preferred stock, of at least 200%. This requirement limits the
amount that we may borrow. As of September 30, 2009, we were in compliance with this
requirement. To fund growth in our investment portfolio in the future, we anticipate
needing to raise additional capital from various sources, including the equity
markets and the securitization or other debt-related markets, which may or may not be
available on favorable terms, if at all.

Finally, in light of the conditions in the financial markets and the
U.S. economy overall, we have taken or are considering taking other measures to help
ensure adequate liquidity, including the use of leverage through a
licensed small business investment company, or SBIC, subsidiary.

45

In
this regard, on February 3, 2010, our wholly-owned subsidiary, Fifth
Street Mezzanine Partners IV, L.P., received a license, effective February 1, 2010, from
the United States Small Business Administration, or SBA, to operate as an SBIC under Section 301(c) of the Small Business Investment Act of 1958.
SBICs are
designated to stimulate the flow of private equity capital to eligible small
businesses. Under SBA regulations, SBICs may make loans to eligible small businesses
and invest in the equity securities of small businesses.

The
SBIC license allows our SBIC subsidiary to obtain
leverage by issuing SBA-guaranteed debentures, subject to the issuance of a capital
commitment by the SBA and other customary procedures. SBA-guaranteed debentures are
non-recourse, interest only debentures with interest payable semi-annually and have a
ten year maturity. The principal amount of SBA-guaranteed debentures is not required
to be paid prior to maturity but may be prepaid at any time without penalty. The
interest rate of SBA-guaranteed debentures is fixed at the time of issuance at a
market-driven spread over U.S. Treasury Notes with 10-year maturities.

SBA regulations currently limit the amount that our SBIC subsidiary may
borrow up to a maximum of $150 million when it has at least $75 million in regulatory
capital, receives a capital commitment from the SBA and has been through an
examination by the SBA subsequent to licensing. As of December 31, 2009, our SBIC
subsidiary had funded four pre-licensing investments for a total of $73 million and
held $2 million in cash, which is included as regulatory capital. The SBA is expected to issue a
capital commitment to our SBIC subsidiary in the near future, at
which point our SBIC
subsidiary would be able to access to a portion of the capital
commitment. However, we cannot
predict the timing for completion of an examination by the SBA, at
which time the SBA reviews our SBIC
subsidiary and determines whether it conforms with SBA rules and regulations. We expect to
have access to the full amount over time.

The SBA restricts the ability of SBICs to repurchase their capital stock.
SBA regulations also include restrictions on a change of control or transfer of an
SBIC and require that SBICs invest idle funds in accordance with SBA regulations. In
addition, our SBIC subsidiary may also be limited in its ability to make
distributions to us if it does not have sufficient capital, in accordance with SBA
regulations.

Our
SBIC subsidiary is subject to
regulation and oversight by the SBA, including requirements with respect to
maintaining certain minimum financial ratios and other covenants. Receipt of an SBIC
license does not assure that our SBIC subsidiary will receive SBA guaranteed
debenture funding, which is dependent upon our SBIC subsidiary continuing to be in
compliance with SBA regulations and policies.

The SBA, as a creditor, will have a superior claim to our SBIC subsidiarys
assets over our stockholders in the event we liquidate our SBIC subsidiary or the SBA
exercises its remedies under the SBA-guaranteed debentures issued by our SBIC subsidiary upon an
event of default.

We applied for exemptive relief from the SEC to permit us to exclude the
debt of our SBIC subsidiary guaranteed by the SBA from our 200% asset coverage test under the 1940 Act. If we receive an exemption for this SBA debt, we would have
increased flexibility under the 200% asset coverage test.

We cannot assure you that we will receive the exemptive relief from the
SEC or a capital commitment from the SBA necessary to begin
issuing SBA-guaranteed debentures.

We cannot provide any assurance that these measures will provide sufficient
sources of liquidity to support our operations and growth given the unprecedented
instability in the financial markets and the weak U.S. economy.

Borrowings

On November 16, 2009, Fifth Street Funding, LLC, a wholly-owned bankruptcy
remote, special purpose subsidiary, or Funding, and we, entered into a Loan and
Servicing Agreement, or the Loan Agreement, with respect to a three-year credit
facility, or the Facility, with Wachovia, Wells Fargo Securities, LLC, as
administrative agent, each of the additional institutional and conduit lenders party
thereto from time to time, and each of the lender agents party thereto from time to
time, in the amount of $50 million with an accordion feature, which allows for
potential future expansion of the Facility up to $100 million. The Facility is
secured by all of the assets of Funding, and all of our equity interest in Funding.
The Facility bears interest at LIBOR plus 4% per annum and has a maturity date of
November 16, 2012. The Facility may be extended for up to two additional years upon
the mutual consent of Wells Fargo Securities, LLC and each of the lender parties thereto. We intend to
use the net proceeds of the Facility to fund a portion of our loan origination
activities and for general corporate purposes.

46

In connection with the Facility, we concurrently entered into (i) a
Purchase and Sale Agreement with Funding, pursuant to which we will sell to Funding
certain loan assets we have originated or acquired, or will originate or acquire and
(ii) a Pledge Agreement with Wells Fargo Bank, National Association, pursuant to
which we pledged all of our equity interests in Funding as security for the payment
of Fundings obligations under the Loan Agreement and other documents entered
into in connection with the Facility.

The
Loan Agreement and related agreements governing the Facility
required both Funding and us to, among other things (i) make representations and
warranties regarding the collateral as well as each of our businesses, (ii) agree to
certain indemnification obligations, and (iii) comply with various covenants,
servicing procedures, limitations on acquiring and disposing of assets, reporting
requirements and other customary requirements for similar credit facilities. The
Facility documents also included usual and customary default provisions such as the
failure to make timely payments under the Facility, a change in control of Funding,
and the failure by Funding or us to materially perform under the Loan Agreement
and related agreements governing the Facility, which, if not complied with, could
accelerate repayment under the Facility, thereby materially and adversely affecting
our liquidity, financial condition and results of operations.

Each loan origination under the Facility is subject to the satisfaction of
certain conditions. We cannot assure you that Funding will be able to borrow funds
under the Facility at any particular time or at all.

We also gave notice of termination, effective September 16, 2009, to Bank
of Montreal with respect to a $50 million revolving credit facility. The revolving
credit facility was scheduled to expire on December 29, 2009 and had an interest rate
of LIBOR plus 3.25% per annum.

Since our inception we have had funds available under the following
agreements which we repaid or terminated prior to our election to be regulated as a
business development company:

Note Agreements. We received loans of $10 million on March 31, 2007 and
$5 million on March 30, 2007 from Bruce E. Toll, a former member of our Board of
Directors, on each occasion for the purpose of funding our investments in portfolio
companies. These note agreements accrued interest at 12% per annum. On April 3, 2007,
we repaid all outstanding borrowings under these note agreements.

Loan Agreements. On January 15, 2008, we entered into a $50 million
secured revolving credit facility with the Bank of Montreal, at a rate of LIBOR plus
1.5% per annum, with a one year maturity date. The secured revolving credit facility
was secured by our existing investments. On December 30, 2008, Bank of Montreal
renewed our $50 million credit facility. The terms included a 50 basis points
commitment fee, an interest rate of LIBOR plus 3.25% per annum and a term of
364 days. On September 16, 2009, we gave notice of termination to Bank of Montreal
with respect to this credit facility.

On April 2, 2007, we entered into a $50 million loan agreement with
Wachovia, which was available for funding investments. The borrowings under the loan
agreement accrued interest at LIBOR plus 0.75% per annum and had a maturity date in
April 2008. In order to obtain such favorable rates, Mr. Toll, a former member of our
Board of Directors, Mr. Tannenbaum, our president and chief executive officer, and
FSMPIII GP, LLC, the general partner of our predecessor fund, each guaranteed our
repayment of the $50 million loan. We paid Mr. Toll a fee of 1% per annum of the
$50 million loan for such guarantee, which was paid quarterly or monthly at our
election. Mr. Tannenbaum and FSMPIII GP received no compensation for their respective
guarantees. As of November 27, 2007, we repaid and terminated this loan with
Wachovia.

Off-Balance Sheet Arrangements

We may be a party to financial instruments with off-balance sheet risk in
the normal course of business to meet the financial needs of our portfolio companies.
As of December 31, 2009, our only off-balance sheet arrangements consisted of
$32.1 million of unfunded commitments, which was comprised of
$30.3 million to provide
debt financing to certain of our portfolio companies and $1.8 million related to
unfunded limited partnership interests. As of September 30, 2009, our only
off-balance sheet arrangements consisted of $9.8 million of unfunded commitments,
which was comprised of $7.8 million to provide debt financing to certain of our
portfolio companies and $2.0 million related to unfunded limited partnership
interests. Such commitments involve, to varying degrees,

47

elements of credit risk in excess of the amount recognized in the balance sheet
and are not reflected on our Consolidated Balance Sheets.

Contractual
Obligations

A summary of the composition of unfunded commitments (consisting of
revolvers, term loans and limited partnership interests) as of December 31, 2009 and
September 30, 2009 is shown in the table below:

December 31, 2009

September 30, 2009

Storyteller Theaters Corporation

$

1,500,000

$

1,750,000

HealthDrive Corporation

1,500,000

1,500,000

IZI Medical Products, Inc.

2,500,000

2,500,000

Trans-Trade, Inc.

2,000,000

2,000,000

Riverlake Equity Partners II, LP (limited partnership interest)

1,000,000

1,000,000

Riverside Fund IV, LP (limited partnership interest)

846,028

1,000,000

ADAPCO, Inc.

5,750,000



AmBath/ReBath
Holdings, Inc.

3,000,000



JTC
Education, Inc.

10,000,000



Tegra
Medical, LLC

4,000,000



Total

$

32,096,028

$

9,750,000

We have entered into two contracts under which we have material future
commitments, the investment advisory agreement, pursuant to which Fifth Street
Management LLC has agreed to serve as our investment adviser, and the administration
agreement, pursuant to which FSC, Inc. has agreed to furnish us with the facilities
and administrative services necessary to conduct our day-to-day operations.

As discussed above, on November 16, 2009, we entered into a three-year
credit facility with Wachovia, in the amount of $50 million with an accordion
feature, which allows for potential future expansion of the facility up to
$100 million, and bears interest at LIBOR plus 4% per annum. We also gave notice
of termination, effective September 16, 2009, to Bank of Montreal with respect to our
existing $50 million revolving credit facility with Bank of Montreal. The revolving
credit facility with Bank of Montreal was scheduled to expire on December 29, 2009
and had an interest rate of LIBOR plus 3.25%.

Regulated Investment Company Status and Distributions

Effective as of January 2, 2008, Fifth Street Mezzanine Partners III, L.P.
merged with and into Fifth Street Finance Corp., which has elected to be treated as a
business development company under the 1940 Act. We elected, effective as of
January 2, 2008, to be treated as a RIC under Subchapter M of the Code. As long as we
qualify as a RIC, we will not be taxed on our investment company taxable income or
realized net capital gains, to the extent that such taxable income or gains are
distributed, or deemed to be distributed, to stockholders on a timely basis.

Taxable income generally differs from net income for financial reporting
purposes due to temporary and permanent differences in the recognition of income and
expenses, and generally excludes net unrealized appreciation or depreciation until
realized. Distributions declared and paid by us in a year may differ from taxable
income for that year as such distributions may include the distribution of current
year taxable income or the distribution of prior year taxable income carried forward
into and distributed in the current year. Distributions also may include returns of
capital.

To maintain RIC tax treatment, we must, among other things, distribute,
with respect to each taxable year, at least 90% of our investment company taxable
income (i.e., our net ordinary income and our realized net short-term capital gains
in excess of realized net long-term capital losses, if any). As a RIC, we are also
subject to a federal

48

excise tax, based on distributive requirements of our taxable income on a
calendar year basis (e.g., calendar year 2010). We anticipate timely distribution of
our taxable income within the tax rules; however,
we incurred a de minimis U.S. federal excise tax for calendar year
2008 and have accrued a de minimis U.S. federal
excise tax for calendar year 2009. In addition, we may incur a U.S. federal excise tax in
future years. We intend to make distributions to our stockholders on a quarterly
basis of between 90% and 100% of our annual taxable income (which includes our
taxable interest and fee income). However, in future periods, we will be partially dependent on our SBIC
subsidiary for cash distributions to enable us to meet the RIC distribution
requirements. Our SBIC subsidiary may be limited by the Small Business Investment Act
of 1958, and SBA regulations governing SBICs, from making certain distributions to us
that may be necessary to enable us to maintain our status as a RIC. We may have to
request a waiver of the SBAs restrictions for our SBIC subsidiary to make certain
distributions to maintain our RIC status. We cannot assure you that the SBA will
grant such waiver. In addition, we may retain for investment some or all of our net
taxable capital gains (i.e., realized net long-term capital gains in excess of
realized net short-term capital losses) and treat such amounts as deemed
distributions to our stockholders. If we do this, our stockholders will be treated as
if they received actual distributions of the capital gains we retained and then
reinvested the net after-tax proceeds in our common stock. Our stockholders also may
be eligible to claim tax credits (or, in certain circumstances, tax refunds) equal to
their allocable share of the tax we paid on the capital gains deemed distributed to
them. To the extent our taxable earnings for a fiscal taxable year fall below the
total amount of our distributions for that fiscal year, a portion of those
distributions may be deemed a return of capital to our stockholders.

We may not be able to achieve operating results that will allow us to make
distributions at a specific level or to increase the amount of these distributions
from time to time. In addition, we may be limited in our ability to make
distributions due to the asset coverage test for borrowings applicable to us as a
business development company under the 1940 Act and due to provisions in our credit
facility. If we do not distribute a certain percentage of our taxable income
annually, we will suffer adverse tax consequences, including possible loss of our
status as a RIC. We cannot assure stockholders that they will receive any
distributions or distributions at a particular level.

Pursuant to a recent revenue procedure (Revenue Procedure 2010-12), or the
Revenue Procedure, issued by the Internal Revenue Service, or IRS, the IRS has
indicated that it will treat distributions from certain publicly traded RICs
(including BDCs) that are paid part in cash and part in stock as dividends that would
satisfy the RICs annual distribution requirements and qualify for the dividends paid
deduction for federal income tax purposes. In order to qualify for such treatment,
the Revenue Procedure requires that at least 10% of the total distribution be payable
in cash and that each stockholder have a right to elect to receive its entire
distribution in cash. If too many stockholders elect to receive cash, each
stockholder electing to receive cash must receive a proportionate share of the cash
to be distributed (although no stockholder electing to receive cash may receive less
than 10% of such stockholders distribution in cash). This Revenue Procedure applies
to distributions declared on or before December 31, 2012 with respect to taxable
years ending on or before December 31, 2011. We have no current intention of paying
dividends in shares of our stock.

Related Party Transactions

We have entered into an investment advisory agreement with Fifth Street
Management, our investment adviser. Fifth Street Management is controlled by Leonard
M. Tannenbaum, its managing member and our president and chief executive officer.
Pursuant to the investment advisory agreement, payments will be equal to (a) a base
management fee of 2% of the value of our gross assets, which includes any borrowings
for investment purposes, and (b) an incentive fee based on our performance.

Pursuant to the administration agreement with FSC, Inc., FSC, Inc. will
furnish us with the facilities and administrative services necessary to conduct our
day-to-day operations, including equipment, clerical, bookkeeping and recordkeeping
services at such facilities. In addition, FSC, Inc. will assist us in connection with
the determination and publishing of our net asset value, the preparation and filing
of tax returns and the printing and dissemination of reports to our stockholders. We
will pay FSC, Inc. our allocable portion of overhead and other expenses incurred by
it in performing its obligations under the administration agreement, including a
portion of the rent and the compensation of our chief financial officer and his
staff, and the staff of our chief compliance officer. Each of these contracts may be
terminated by either party without penalty upon no fewer than 60 days written notice
to the other.

49

We have also entered into a license agreement with Fifth Street Capital LLC
pursuant to which Fifth Street Capital LLC has agreed to grant us a non-exclusive,
royalty-free license to use the name Fifth Street. Fifth Street Capital LLC is
controlled by Mr. Tannenbaum, its managing member. Under this agreement, we will have
a right to use the Fifth Street name, for so long as Fifth Street Management LLC or
one of its affiliates remains our investment adviser. Other than with respect to this
limited license, we will have no legal right to the Fifth Street name.

Recent Devlopments

On January 6, 2010, we announced that our external investment adviser has
voluntarily agreed to take the following actions:



To waive the portion of its base management fee for the
quarter ended December 31, 2009 attributable to four new
portfolio investments, as well as cash and cash
equivalents. The amount of the management fee being waived
is approximately $727,000; and



To permanently waive that portion of its base management
fee attributable to our assets held in the form of cash
and cash equivalents as of the end of each quarter
beginning March 31, 2010.

For purposes of the waiver, cash and cash equivalents is as defined in the notes
to our Consolidated Financial Statements.

On January 6, 2010, we filed a preliminary proxy statement with the SEC for our 2010 Annual Meeting of Stockholders. Among
other things, we plan to seek stockholder approval to increase the number of
authorized shares of our common stock and to remove our authority to issue shares of Series A Preferred Stock. We also announced that we do not intend to
seek additional approval of our stockholders at our 2010 Annual Meeting of
Stockholders to sell or otherwise issue shares of our common stock at a price below
the then-current net asset value per share.

On January 6, 2010, AmBath/ReBath Holdings, Inc. drew $0.8 million on
its previously undrawn credit line. Prior to the draw, our unfunded
commitment was $3.0 million.

On January 12, 2010, our Board of Directors declared a distribution of $0.30 per
share, payable on March 30, 2010 to stockholders of record on March 3, 2010. In
connection with the distribution declaration, we also announced that as we originate
more deals, we expect our quarterly distribution to continue to increase during the
fiscal year. The timing and amount of any distribution is at the discretion of our
Board of Directors.

On January 14, 2010, we provided a $2.5 million revolving credit line to
Vanguard Vinyl, Inc. (formerly known as Best Vinyl Acquisition Corporation), of which
$1.25 million was drawn at closing. This investment, along with the proceeds from the
sale of a non-core asset and an additional investment by the equity sponsor, were
utilized to pay off the companys existing senior debt. In connection with this
transaction, we received a first lien security interest on all of the assets of the
company. On January 21, 2010, Vanguard Vinyl, Inc. drew an additional $0.25 million
on this credit line.

On January 15, 2010, we repaid $0.2 million of the outstanding balance on our secured revolving credit
facility with Wachovia. On January 28, 2010, we repaid $25.0 million of the outstanding balance on the facility.
On January 29, 2010, we repaid in full the outstanding balance of $12.8 million on the facility.

On January 21, 2010, we announced that we have received a non-binding term sheet
from a lender in connection with a potential additional credit line of up to
$100 million. The term sheet is subject to completion of due diligence and execution
of definitive documents. We cannot assure you that we will enter into any additional
new financings.

On January 27, 2010, we completed a public offering of 7,000,000 shares of our common stock at a price
of $11.20 per share. The net proceeds totaled approximately $74.9 million after deducting investment banking
commissions of approximately $3.5 million.

On January 29, 2010, we closed
a $21.8 million senior secured debt facility to support the acquisition of a specialty food company. The investment
is backed by a private equity sponsor and $20.3 million was funded at closing. The terms of
this investment include a $1.5 million revolver at an interest rate of 10% per annum,
a $7.6 million Term Loan A at an interest rate of 10% per annum, and a $12.7 million Term
Loan B at an interest rate of 12% per annum in cash and 3% PIK. This is a first lien facility
with a scheduled maturity of five years.

On February 1, 2010, TBA
Global, LLC repaid $2.5 million of principal outstanding under its Term Loan A.

On
February 3, 2010, our wholly-owned subsidiary, Fifth Street Mezzanine
Partners IV, L.P., received a license, effective February 1, 2010, from the SBA to operate
as an SBIC under Section 301(c) of the Small Business Investment Act of 1958.

Recently Issued Accounting Standards

See Note 2 to the Consolidated Financial Statements for a description of
recent accounting pronouncements, including the expected dates of adoption and the
anticipated impact on the Consolidated Financial Statements.

50

Item 3. Quantitative and Qualitative Disclosure about Market Risk

We are subject to financial market risks, including changes in interest rates.
Changes in interest rates may affect both our cost of funding and our interest income
from portfolio investments, cash and cash equivalents and idle funds investments. Our
risk management systems and procedures are designed to identify and analyze our risk,
to set appropriate policies and limits and to continually monitor these risks and
limits by means of reliable administrative and information systems and other policies
and programs. Our investment income will be affected by changes in various interest
rates, including LIBOR and prime rates, to the extent any of our debt investments
include floating interest rates. The significant majority of our debt investments are
made with fixed interest rates for the term of the investment. However, as of
December 31, 2009, approximately 18.9% of our debt investment portfolio (at fair
value) and 18.2% of our debt investment portfolio (at cost) bore interest at floating
rates. As of December 31, 2009, we had not entered into any interest rate hedging
arrangements. At December 31, 2009, based on our applicable levels of floating-rate
debt investments, a 1.0% change in interest rates would not have a material effect on
our level of interest income from debt investments.

Our investments are carried at fair value as determined in good faith by
our Board of Directors in accordance with the 1940 Act (See
Item 2. Managements Discussion and Analysis of Financial
Condition and Results of Operations  Critical Accounting Policies
 Investment Valuation). Our valuation methodology utilizes discount
rates in part in valuing our investments, and changes in those discount rates may
have an impact on the valuation of our investments. Assuming no changes in our
investment and capital structure, a hypothetical increase or decrease in discount
rates of 100 basis points would increase or decrease our net assets resulting from
operations by approximately $12 million.

Item 4. Controls and Procedures

(a)

As of the end of the period covered by this report, we carried out an evaluation,
under the supervision and with the participation of our management, including
our Chief Executive Officer and Chief Financial Officer, of the effectiveness of
the design and operation of our disclosure controls and procedures (as defined in
Rule 13a-15 of the Securities Exchange Act of 1934). Based on that evaluation, our Chief
Executive Officer and our Chief Financial Officer concluded that our disclosure
controls and procedures were effective in timely alerting them of material information
relating to us that is required to be disclosed in the reports we file or submit under the
Securities Exchange Act of 1934.

(b)

Changes in Internal Controls

We have identified a significant deficiency in our internal control over
financial reporting with respect to our research and application of U.S. generally
accepted accounting principles, or GAAP. A significant deficiency is a deficiency,
or a combination of deficiencies, in internal control over financial reporting that
is less severe than a material weakness, yet important enough to merit attention by
those responsible for oversight of a companys financial reporting. A material
weakness is a deficiency, or combination of deficiencies, in internal control over
financial reporting, such that there is a reasonable possibility that a material
misstatement of a companys annual or interim financial statements will not be
prevented or detected on a timely basis.

In particular, the significant deficiency pertains to our policy associated
with investments that contain contractual exit fees. Exit fees, which are payable by
borrowers to us upon the repayment to us of a loan or debt security, previously were
to be recognized by us on a cash basis when received and not accrued or otherwise
included in net investment income until received. None of the loans with exit fees,
all of which were originated in 2008 and 2009, have been exited and, as a result, no
exit fees were recognized. We concluded that this treatment revealed a significant
deficiency in our internal control over financial reporting. Beginning with the
quarter ended December 31, 2009, we recognize income pertaining to contractual
exit fees on an accrual basis and add exit fee income to the principal balance of the
related loan to the extent we determine that collection of the exit fee income is
probable. Additionally, we include the cash flows of contractual exit fees that
we determine are probable of collection in determining the fair value of our loans.
We believe the effect of this cumulative adjustment in the quarter ended December 31,
2009 is not material to our financial statements as of any date or for any
period.

We have begun the process of remediating this significant deficiency.
No other change in our internal control over financial reporting during our most recent
fiscal quarter have materially affected, or are reasonably likely to materially affect,
our internal control over financial reporting.

51

PART II  OTHER INFORMATION

Item 1. Legal Proceedings.

Although we may, from time to time, be involved in litigation arising out of our
operations in the normal course of business or otherwise, we are currently not a party to any
pending material legal proceedings.

Item 1A. Risk Factors.

Except as described below, there have been no material changes during the three months
ended December 31, 2009 to the risk factors discussed in Item 1A. Risk Factors in our Annual Report
on Form 10-K for the year ended September 30, 2009.

On
February 3, 2010, our wholly-owned subsidiary, Fifth Street Mezzanine
Partners IV, L.P., received a license, effective February 1, 2010, from the SBA to operate
as an SBIC under Section 301(c) of the Small Business Investment Act
of 1958 and is regulated by the SBA. The SBIC license
allows our SBIC subsidiary
to obtain leverage by issuing SBA-guaranteed debentures, subject to the issuance of a
capital commitment by the SBA and other customary procedures. The SBA places certain
limitations on the financing terms of investments by SBICs in portfolio companies and
prohibits SBICs from providing funds for certain purposes or to businesses in a few
prohibited industries. Compliance with SBIC requirements may cause our SBIC
subsidiary to forego attractive investment opportunities that are not permitted under
SBA regulations.

SBA regulations currently limit the amount that our SBIC subsidiary may
borrow up to a maximum of $150 million when it has at least $75 million in regulatory
capital, receives a capital commitment from the SBA and has been through an
examination by the SBA subsequent to licensing. As of December 31, 2009, our SBIC
subsidiary had funded four pre-licensing investments for a total of $73 million and
held $2 million in cash, which will be included as regulatory capital. The SBA is expected to issue a
capital commitment to our SBIC subsidiary in the near future, at
which point our SBIC subsidiary would be able to access a portion of
the capital commitment. However, we cannot
predict the timing for completion of an examination by the SBA, at
which time the SBA reviews our SBIC subsidiary
and determines whether it conforms with SBA rules and regulations.

Further, SBA regulations require that a licensed SBIC be periodically
examined and audited by the SBA to determine its compliance with the relevant SBA
regulations. The SBA prohibits, without prior SBA approval, a change of control of
an SBIC or transfers that would result in any person (or a group of persons acting in
concert) owning 10% or more of a class of capital stock of a licensed SBIC. If our
SBIC subsidiary fails to comply with applicable SBA regulations, the SBA could,
depending on the severity of the violation, limit or prohibit its use of debentures,
declare outstanding debentures immediately due and payable, and/or limit it from
making new investments. In addition, the SBA can revoke or suspend a license for
willful or repeated violation of, or willful or repeated failure to observe, any
provision of the Small Business Investment Act of 1958 or any rule or regulation
promulgated thereunder. These actions by the SBA would, in turn, negatively affect us
because our SBIC subsidiary is our wholly-owned subsidiary.

We also applied for exemptive relief from the SEC to permit us to exclude
the debt of our SBIC subsidiary guaranteed by the SBA from our 200% asset coverage
test under the 1940 Act. If we receive an exemption for this SBA debt, we would have
increased flexibility under the 200% asset coverage test.

We cannot assure you that we will receive the exemptive relief from the
SEC or a capital commitment from the SBA necessary to begin
issuing SBA-guaranteed debentures.

52

Our wholly-owned SBIC subsidiary may be unable to
make distributions to us that will enable us to meet or maintain RIC status, which
could result in the imposition of an entity-level tax.

In order for us to continue to qualify for RIC tax treatment and to
minimize corporate-level taxes, we will be required to distribute substantially all
of our net ordinary income and net capital gain income, including income from certain
of our subsidiaries, which includes the income from our SBIC subsidiary. We will be
partially dependent on our SBIC subsidiary for cash distributions to enable us to
meet the RIC distribution requirements. Our SBIC subsidiary may be limited by the
Small Business Investment Act of 1958, and SBA regulations governing SBICs, from
making certain distributions to us that may be necessary to maintain our status as a
RIC. We may have to request a waiver of the SBAs restrictions for our SBIC
subsidiary to make certain distributions to maintain our RIC status. We cannot assure
you that the SBA will grant such waiver and if our SBIC subsidiary is unable to
obtain a waiver, compliance with the SBA regulations may result in loss of RIC tax
treatment and a consequent imposition of an entity-level tax on us.

We have identified a significant deficiency in our internal control over
financial reporting. Future control deficiencies could prevent us from accurately and
timely reporting our financial results.

We have identified a significant deficiency in our internal control over
financial reporting with respect to our research and application of U.S. generally
accepted accounting principles, or GAAP. A significant deficiency is a deficiency,
or a combination of deficiencies, in internal control over financial reporting that
is less severe than a material weakness, yet important enough to merit attention by
those responsible for oversight of a companys financial reporting. A material
weakness is a deficiency, or combination of deficiencies, in internal control over
financial reporting, such that there is a reasonable possibility that a material
misstatement of a companys annual or interim financial statements will not be
prevented or detected on a timely basis.

In particular, the significant deficiency pertains to our policy associated
with investments that contain contractual exit fees. Exit fees, which are payable by
borrowers to us upon the repayment to us of a loan or debt security, previously were
to be recognized by us on a cash basis when received and not accrued or otherwise
included in net investment income until received. None of the loans with exit fees,
all of which were originated in 2008 and 2009, have been exited and, as a result, no
exit fees were recognized. We concluded that this treatment revealed a significant
deficiency in our internal control over financial reporting. Beginning with the
quarter ended December 31, 2009, we recognize income pertaining to contractual
exit fees on an accrual basis and add exit fee income to the principal balance of the
related loan to the extent we determine that collection of the exit fee income is
probable. Additionally, we include the cash flows of contractual exit fees that
we determine are probable of collection in determining the fair value of our loans.
We believe the effect of this cumulative adjustment in the quarter ended December 31,
2009 is not material to our financial statements as of any date or for any
period.

Our
failure to identify deficiencies in our internal control over financial reporting in
a timely manner or remediate any existing significant deficiencies, or the
identification of material weaknesses or other significant deficiencies in the future
could prevent us from accurately and timely reporting our financial results.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

We issued a total of 44,420 shares of common stock under our dividend reinvestment
plan during the three months ended December 31, 2009. This issuance was not subject to the
registration requirements of the Securities Act of 1933. The aggregate price for the shares of
common stock issued under the dividend reinvestment plan was approximately $0.5 million.

53

Item 6. Exhibits.

Exhibit

Number

Description of Exhibit

31.1*

Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934.

31.2*

Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934.

Site Links

Based on public records. Inadvertent errors are possible. Getfilings.com does not guarantee the accuracy or timeliness of any information on this site. Use at your own risk.
This website is not associated with the SEC.